Editor's note: Our "On the Brink" series will provide daily insight into the financial firms facing capital shortfalls and the growing pressure from short sellers in the market.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
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.