Why AIG Is Devouring the Bailout Fund

If there's one company whose fate foretells where the rest of the economy is headed, it's AIG.

When the nearly insolvent insurance giant took an extraordinary $85 billion loan from the government in September, it signaled that financial tremors were spreading beyond Wall Street banks into other industries—and into 130 countries where AIG does business. In October, AIG got another infusion of $38 billion from the feds, as the stock markets tanked and the economy careened downward. Now, as AIG has announced a mammoth $25 billion third-quarter loss, the government has essentially scrapped its first two AIG rescue plans in favor of more aggressive treatment that reveals how much intervention is still required to prevent a financial epidemic.

The new plan effectively lowers the interest rate AIG must pay the government on $60 billion worth of loans and extends the payback period from two years to five. The government will also buy $40 billion in AIG stock and spend an additional $50 billion or so buying AIG-held securities that nobody else wants right now, at any price.

The terms of the new deal might sound arcane, but they're worth paying attention to. AIG is the gorilla in the coal mine, and its demise would trigger severe Darwinian fallout that would make the Lehman Brothers liquidation look like the death of a snail. That's why the government is all but wheeling AIG around on a gurney and why the big firm's fate has implications for virtually every consumer, even if you've never bought an AIG insurance policy. Here's what AIG's problems mean for the rest of us:

The financial crisis is far from over. Don't be fooled just because those wild stock market gyrations seem to have subsided—there could still be plenty of bad news ahead. AIG's condition is clearly more dire than regulators and company executives first thought, which is why the government has restructured the AIG bailout and nearly doubled the amount of federal aid to the company. That means other companies are likely to founder as well—including some that are AIG trading partners. They may not be as integral to the rest of the financial system as AIG is, but their problems will rattle markets for some time to come and contribute to unemployment.

Conventional fixes aren't working. After the first $85 billion loan, some AIG executives and shareholders hoped the firm would quickly sell assets, pay off the federal loan, and regain control of itself. But it couldn't. AIG has plenty to sell, including a profitable life-insurance business, global port operations, and the world's biggest fleet of jetliners, which it leases to airlines worldwide. But the credit freeze has made it hard for even healthy companies to find the cash for such big purchases. And if AIG were forced to sell at fire-sale prices, it would depress the entire market for those assets, deepening the recession. That's why the government, among other things, has given AIG more time to hold out for a fair price for some of its most valuable holdings. But there's still no guarantee that this will save the company, and the government might have to dip even deeper into its bag of very expensive tricks.

The financial crisis is self-fulfilling. This unnerves economists, because self-reinforcing economic spirals are extremely hard to combat through ordinary government measures. AIG helped trigger the overall financial crisis and the credit freeze that followed, through vast amounts of credit-default swaps and other securities it nearly defaulted on. If it could happen to AIG—once considered a gold-plated risk—then it could happen to any firm, which is why banks are suddenly afraid to lend. And now, AIG is suffering the blow-back of its own failures as much as anybody, since it desperately needs liquidity and functioning markets in order to sell assets. Yet even with federal help, AIG is struggling to stay afloat.

The bailout fund is quickly being depleted. Who would have thought it could be so easy to spend $700 billion? Federal commitments to AIG alone amount to more than one fifth of the entire bailout fund. The government should get at least some of that money back—assuming AIG stays in business and repays its loans and the feds eventually sell some of those pungent securities. But that won't happen for years, while other ailing giants like Fannie Mae and Freddie Mac may soon need a lot of help. Then there are the Detroit automakers, along with other insurers and perhaps dozens of regional banks that are lined up, asking for a bailout. Not long ago, companies turned to AIG to provide insurance against these kinds of catastrophes. Now the American taxpayer is the insurer of last resort.