Fed rescues giant insurer AIG

In return for an $85 billion loan, the government will get a stake of almost 80 percent

WASHINGTON -- Acting to avert a possible financial crisis worldwide, the Federal Reserve reversed course Tuesday and agreed to an $85 billion bailout that would give the government a 79.9 percent stake in troubled insurance giant American International Group, the Fed announced Tuesday night.

The decision, only two weeks after the Treasury took over quasi-government mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank's history.

With time running out after AIG failed to get a bank loan to avoid bankruptcy, Treasury Secretary Henry M. Paulson and Fed Chairman Ben S. Bernanke convened a meeting with House and Senate leaders on Capitol Hill about 6:30 p.m. Tuesday to explain the rescue plan.

They emerged just after 7:30 with Paulson and Bernanke looking grim but top lawmakers generally expressing support for the plan. But the bailout is likely to prove controversial, because it effectively puts taxpayer money at risk while protecting bad investments made by AIG and other institutions it does business with.

The Federal Reserve said in a statement that a disorderly failure of AIG could hurt the already delicate financial markets and the economy, the Associated Press reported.

It could also "lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," the Fed said.

"The president supports the agreement announced this evening by the Federal Reserve," said White House spokesman Tony Fratto. "These steps are taken in the interest of promoting stability in financial markets and limiting damage to the broader economy."

A scary prospect

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but AIG's role as an enormous provider of financial insurance, which effectively requires it to cover losses suffered by other institutions in the instance of defaults of securities that they have purchased. That means AIG is potentially on the hook for securities that were once considered safe.

If AIG had collapsed -- and been unable to pay all of its insurance claims -- institutional investors around the world would have been instantly forced to reappraise the value of billions of dollars in debt securities, which in turn would have reduced their own capital and the value of their own debt.

"It would have been a chain reaction," said Uwe Reinhardt, a professor of economics at Princeton University. "The spillover effects could have been incredible."

Financial markets, which on Monday had plunged over worries about AIG's possible collapse, reacted with relief to the news of the bailout. In anticipation of a deal, stocks rose about 1 percent in the U.S. on Tuesday and were up about 2 percent in early trading in Asian markets Wednesday morning.

Still, the move will likely spark an intense political debate during the presidential election campaign over who is to blame for the financial crisis that prompted the rescue.

The decision was a remarkable turnabout by the Bush administration and Paulson, who had flatly refused over the weekend to risk taxpayer money to prevent the collapse of Lehman Brothers or the distressed sale of Merrill Lynch to Bank of America. Earlier this year, the government bailed out another investment bank, Bear Stearns, by engineering a sale to JPMorgan Chase that left taxpayers on the hook for up to $29 billion of bad investments by Bear Stearns.

The government hoped at the time that this unusual step would both calm markets and lead to a recovery by the financial system. But critics warned at the time that it would only encourage others to seek bailouts, and the eventual costs to the government would be staggering.

Fed and Treasury officials initially had turned a cold shoulder to AIG when company executives pleaded on Sunday night for the Fed to provide a $40 billion bridge loan to stave off a crippling downgrade of its credit ratings as a result of tens of billions of dollars of losses related to insurance investments that have turned sour.

Government officials reluctantly backed away from their tough-minded approach after a failed attempt to line up private financing with help from JPMorgan Chase and Goldman Sachs, which told federal officials they simply could not raise the money, given both the general angst in credit markets and the specific fears of problems with AIG.