According to the NYTimes:
The debate within the Fed centered on which part of the government could provide the guarantee, according to the documents. Staff at the Board of Governors told Fed officials in New York that a Fed guarantee “was off the table,” according to an e-mail message to Mr. Geithner and others on Oct. 15 from Sarah Dahlgren, the New York Fed official overseeing the A.I.G. rescue.
“We countered with questions about why it was so clearly off the table and suggested, as well, that perhaps this was something that Treasury could do,” Ms. Dahlgren continued.
Supporters of the plan considered a guarantee a good option because A.I.G.’s debt rating was at risk of a downgrade by the credit rating agencies and the company would then have to post more collateral with the banks.
“If a ratings downgrade happens at any time in the next three weeks or afterward, we will need this to protect any value in the insurance companies and, importantly, to avoid a disorderly seizure,” Ms. Dahlgren wrote.
The New York Fed pursued the guarantee option with the Treasury, the documents indicate. But by Oct. 23, the Treasury had refused to provide the guarantee, according to an e-mail message sent by Ms. Dahlgren to Mr. Geithner. In early November, the Fed decided to make the counterparties whole on their insurance contracts.
How does Treasury explain its decision not to provide a guarantee to the AIG CDOs that were absorbing so much collateral? This would clearly have saved taxpayer money in the short-run — and would be unlikely to end up adding to taxpayer losses in the long-run. (As far as I can see, the only situation in which Maiden Lane III is a better choice for Treasury than an outright guarantee of the same assets is if Blackrock manages to pull off an extraordinarily well timed sale of the CDOs, thus transferring yet to be realized losses to someone in the private sector.)
Synthetic Assets 
I don’t get the anxiety. If they had guaranteed the remaining CDO valuations, they would be creating a potential liability to the government of 27 billion dollars. The CPs would still be there. They would still have contractual rights, including cross-default clauses. If AIG later defaulted, the government would have to write checks totally 27 billion.
This obsession with counter parties being paid at par totally misses the point. They were trying to stabilize the economy. Note – they did. Ever wonder how? Big part – they killed the CDO issue on the spot, and the economy like that.
Well, yes, they killed the CDO issue and it worked. You’ll notice that my post doesn’t discuss the 100% payout because I think I understand why that decision was made (our current derivatives law acts like a gun to the economy’s head).
My issues are (i) why was the Fed was forced to play a fiscal role, instead — especially after the TARP law was passed — of Treasury doing its job as fiscal agent for the government and (ii) a guarantee would have worked just as well (as you apparently acknowledge), so why not use a guarantee since the optics are better.
One possible answer to (ii) is that the regulators didn’t want to put a formal government backstop behind speculative derivatives, and the only way to be sure to rule this out was to insist on delivery of the underlying. I would like however to see this theory confirmed by first-hand reports.
The answer to (i) remains a complete mystery to me.