Fed saves insurer with $85b loan

AIG was called too big to let fail

CHIP EAST/REUTERSNew York Governor David Paterson, with the state's deputy secretary for labor, Charlotte Hitchcock, and insurance superintendent Eric Dinallo, announced the bailout at a press conference yesterday. Full coverage of the financial crisis, C1. (CHIP EAST/REUTERS)

The Federal Reserve will bail out insurance giant American International Group Inc. with a loan of up to $85 billion, taking an 80 percent stake in the struggling company. The rescue deal comes just days after the government refused to save investment firm Lehman Brothers Holdings Inc. from failure.

Unlike Lehman, analysts said, AIG, a $1 trillion company, was too deeply entangled in global markets and financial firms for the Fed to allow it to fail without putting the financial system at risk.

"If it goes down, it takes too many other institutions with it," said Mark Zandi, chief economist at Moody's Economy.com., a West Chester, Pa., forecasting firm. "It's just too big to fail."

In a statement released last night, the Fed said, "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. 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 loan will have a 24-month term and is expected to be repaid by the sale of AIG assets. The federal government will have veto power over the payment of dividends to shareholders.

The AIG board approved the rescue plan last night.

The bailout came as AIG, desperately trying to raise capital in recent days, was close to filing for bankruptcy. Yesterday, Fed officials, who had previously rebuffed AIG's requests for a government loan, worked with lenders as they tried unsuccessfully to come up with a private financing package. Ultimately, the Fed became the last resort.

Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson briefed congressional leaders last evening, including Representative Barney Frank, the Newton Democrat who chairs the House Financial Services Committee, according to Frank's spokesman, Steven Adamske. Frank had no comment last night, Adamske said.

Senator Charles Schumer, a New York Democrat, who was also briefed on the plan, said in a statement, "The administration is approaching an unprecedented step, but unfortunately we are living in unprecedented times. Hearing of these plans, you have to stop to catch your breath. But upon reflection, the alternatives are much worse."

AIG is another victim of the nation's deep and extended housing downturn. AIG was hurt not only by its holdings of mortgage-backed securities, but also by financial instruments known as credit default swaps. These "swaps" are essentially insurance contracts to protect firms from losses on their pooled mortgage investments.

As long as housing prices were rising and the economy was strong, homeowners paid their mortgages and investors didn't have to pay on their insurance policies. But with more and more Americans falling behind or defaulting on mortgages, Wall Street's players are having to pay money on the insurance contracts they sold to other investors.

The AIG rescue is the latest government bailout of companies that had bet wrong on the housing and mortgage markets. Most recently, in a move that could cost taxpayers tens of billions of dollars, the federal government took over mortgage giants Fannie Mae and Freddie Mac as they faced insolvency. In March, the Fed engineered the sale of investment firm Bear Stearns Cos. by guaranteeing up to $30 billion of its assets.

Last night's unprecedented Fed action is likely to rekindle the debate over whether the government should act to save large companies suffering the consequences of their own risky decisions. That debate subsided briefly when the Fed and US Treasury declined over the weekend to provide financial guarantees to pave the way for a sale of Lehman, which filed for bankruptcy Monday.

Yesterday, British financial services firm Barclays PLC, said it would buy Lehman's stock-trading, underwriting, and merger businesses, according to news reports.

"When the government steps in, the question is where is it going to stop," said Ben Branch, a finance professor at the University of Massachusetts at Amherst. "Washington Mutual? General Motors? Ford?"

Washington Mutual, a national lender, is teetering because of rising mortgage defaults. US auto companies have posted billions of dollars in losses as once-profitable SUVs and light trucks lost favor with buyers in the face of soaring gasoline prices.

The first reports of a potential AIG rescue surfaced yesterday shortly after the Federal Reserve announced it would hold interest rates steady, and helped stocks rebound from their worst dive in seven years, sparked by Lehman's bankruptcy filing. The Dow Jones industrial average recovered 141 of the more than 500 points it lost Monday, closing at 11,059.02. The broader Standard & Poor's 500 index and technology-heavy Nasdaq Composite also posted solid gains.

The gains, however, came after another tumultuous day on Wall Street, with the Dow plunging as much as 150 points, recovering, then plunging again.

The Fed, which last cut rates in April, kept its benchmark rate at a historically low 2 percent. Some analysts had expected policy makers to cut rates to provide an additional boost to the economy in the face of the recent financial turmoil. Instead, Fed officials said they believed the combination of their earlier interest rate cuts and efforts to pump money and credit into the economy would allow the economy to achieve moderate growth.

Still, many analysts expect the Fed to cut rates later as the economy struggles with recession-like conditions. Few see an end to the housing downturn until well into next year, and the job market continues to deteriorate. The national unemployment rate jumped above 6 percent last month, and employers have shed hundreds of thousands of jobs.

In addition, inflation is cooling, thanks to a sharp drop in oil prices. Oil fell more than $4 a barrel in New York yesterday to close just above $91. Oil prices have fallen 37 percent since peaking in July at more than $145 a barrel.

"As the evidence of inflation continues to diminish and the growth weakens, cuts are coming," said Brian Bethune, economist at Global Insight of Waltham. Rate cuts boost the economy by lowering borrowing rates and encouraging businesses and consumers to spend.

Other analysts, however, said Fed rate cuts would have little effect now because lenders, worried about having enough capital to weather the downturn, are reluctant to lend. Several analysts said yesterday the Fed is better off doing what it's done in recent weeks: pumping money, or liquidity, into the financial system to keep it working.

If markets freeze up, it could plunge the economy into a deep downturn, analysts said.

"The Fed has decided that using its liquidity tools are the way to help the markets," said James O'Sullivan, economist at UBS AG in Stamford, Conn. "This AIG news is in that spirit."

Robert Gavin can be reached at rgavin@globe.com. Kim Blanton of the Globe Staff contributed to this report. Material from the Globe wires services was used in this report.