Should we have let them fail?

In a recent WSJ article Oliver Hart and Luigi Zingales suggest that since the main reason behind bailing out the likes of Bear Stearns and AIG because of worries about counter-party risk the government should have instead guaranteed those obligations:

[I]t suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG's viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard.

I'd be very curious to hear more about what others think about this proposal and how workable it would have been. How exactly would the government have guaranteed some of the complex obligations and what kind of risks would it have taken on by doing so? Would this have assuaged investors' concerns?