AIG Bankruptcy Threat Forced Fed's Hand

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Updated from 5 a.m. EDT

A potentially market-rattling bankruptcy filing by American International Group ( AIG) forced federal officials to reverse course and pursue a costly bailout of the insurance giant late Tuesday.

AIG will receive an $85 billion bridge loan from the Federal Reserve aimed at keeping the giant insurer out of bankruptcy and preventing the acceleration of a world credit crisis.

AIG shares fell to as low as $2.42 in extended trading after reports spread of the agreement, which calls for the government to take an 80% stake in the company.

"The Federal Reserve Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance," the central bank said in statement posted on its Web site at 9 p.m. EDT Tuesday.

"This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy." The Fed said the AIG facility has a 24-month term.

The Fed said that "the interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries.

"The loan is expected to be repaid from the proceeds of the sale of the firm's assets. The U.S. government will receive a 79.9% equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders," the statement said.

In a statement early Wednesday, AIG said the transaction is the "best alternative for all of AIG's constituencies, including policyholders, customers, creditors, counterparties, employees and shareholders. AIG is a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues. We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis.

AIG added it expects proceeds of these sales to be sufficient to repay the loan and enable its businesses to continue as "substantial participants in their respective markets."

As part of the deal, Treasury Secretary Henry Paulson insisted that AIG's CEO executive, Robert Willumstad, step aside, the Wall Street Journal reports. Willumstad will be succeeded by Edward Liddy, the former head of insurer Allstate ( ALL).

News of the deal came after AIG shares plummeted a sixth straight day, as the company huddled with officials from the New York Federal Reserve Bank to discuss its option for raising capital. The insurer needed to raise the money by Wednesday to shore up its balance sheet in the wake of devastating ratings downgrades late Monday.

A bankruptcy filing by AIG would have been significantly worse than that of Lehman Brothers ( LEH) in its impact on other financial institutions around the globe, according to several market participants, including the heads of two of the world's largest bond funds.

Though Treasury Secretary Paulson's statements on Monday and the government's refusal to save Lehman Brothers from bankruptcy suggested it has lost its appetite for bailouts, there were several reports late Tuesday that at least some type of federal financial assistance might be on the table for the insurance giant. AIG is also trying to sell assets to raise cash.

"I did not believe the government should play a role in terms of bailing out Lehman," Larry Fink, chairman and CEO of BlackRock ( BLK) told CNBC. "It's different with AIG -- for the market stability, but also because of the nature of AIG and how involved it is in the global financial sweepstakes."

Bill Gross, head of PIMCO, also told CNBC the effect of an AIG bankruptcy would be much worse than that of Lehman. BlackRock and PIMCO together manage more than $2 trillion in credit-related assets.

While AIG has more assets than Lehman, ($1 trillion vs. $600 billion), and provides insurance to countless institutions and people around the world, perhaps the greatest risk of an AIG failure relates to the credit default swap (CDS) market, a multi-trillion dollar private market in which large institutions insure themselves against the risk of default by their debtors.

"An AIG bankruptcy would have enormous consequences, potentially bringing down other big financial institutions around the world through cascading defaults on credit default swaps and other credit derivatives," says Timothy A. Canova, a professor of international economic law at the Chapman University School of Law.

Though Lehman was one of the world's largest players in the credit default swaps market, its role was as largely that of a dealer, meaning its exposures involved more than two parties and were mostly hedged. By contrast, AIG's roughly $441 billion in CDS involved only two parties -- AIG and the buyer -- and are largely not hedged, meaning AIG's trading partners may have no choice but to turn to the insurer to collect on their winning bets -- which AIG may not be able to pay.

Lehman Brothers' trading partners have already started matching off CDS trades involving the firm. UBS ( UBS) on Tuesday said it had mostly resolved its CDS exposure to Lehman at a probable cost of less than $300 million.

Few if any CDS written by AIG are likely to be as easily resolved. Typically, they relate to portfolios of debt securities and pay out if losses reach a certain threshold. Because many debt securities are heavily in the red, AIG will likely have to make lots of payments to parties to which it sold CDS.

About $307 billion of AIG's $447 billion CDS were written for European banks, "for the purpose of providing regulatory capital relief rather than risk mitigation," according to AIG's second-quarter earnings report

Former AIG Chairman Hank Greenberg, AIG's largest shareholder, has filed a 13-D form with the Securities and Exchange Commission, suggesting he may pursue any number of options, including trying to arrange a buyout of AIG or providing some other financial assistance.

Neither Greenberg nor spokesmen for the New York Federal Reserve and AIG responded to requests for comment.

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