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.....then the good banks and even the main street small banks would fail.

Perhaps you can explain why the good banks would necessarily fail? Only reason I can think of is massive unemployment, and people stopping their loan payments in mass. Even during the Depression, some big banks failed, but most did not.

Again, how many trillions $$ is AIG on the hook for? And now, by extension, the taxpayer. Either way, the taxpayer takes it in the shorts. Right now, I think we the financial equivalent of a chicken with its head cut off. We thrash around like we’re alive, but we’re already dead.

Perhaps you can explain why the good banks would necessarily fail

Ok, here goes -- retail banks are in the business of loans and savings and term deposits. Commercial banks help business with this and their payroll process. Investment banks help with raising money for large companies and also diffusing their risk

When companies made loans, those were usually on their books, until the idea of CDOs came about when loans were clubbed together and sold by the lending bank to Investment banks so removing the liability off the lending bank

AIG came up with the brilliant idea of creating insurance policies based on those CDOs and on futures and options of exotic products.

If AIG defaulted, then the banks it owed money to would find that they would have a loss -- and that number would include good banks too.

Secondly, the bad banks who had taken too much of the prime-lending fiasco and didn't have enough cash would collapse without the money from AIG.

The good banks would also lose out that money, but let's assume these good banks still had good money-lending practises and had enough to repay THEIR loans (savings interest and NPA loans).

However, all banks need liquid cash for their day to day transactions and they raise cash from other banks (at the Libor rate or the inter-bank charges rate -- i.e. the % banks lend to other banks). If there was no money in the system, then even the good banks would be cash-strapped. And, when the banks are cash-strapped, they don't loan out money. Many companies also rely on credit to keep operations rolling, so they too would have to shut shop. With their customers shutting shop, banks wouldn't be able to make money off loans. And they would still have to pay out interest on savings (the savings rate would go up as people get more scared) -- so, where could they make that money to pay it out???

ergo, they too would collapse

I repeat - I don't like this, but I think it's the least bad option. AIG is on the hook for billions, not trillions --the trillions are on it's standard insurance portfolio which is still pretty dependable