AIG: The Biggest Bailout

The latest too-big-to-fail failure boosts markets.

By + More

The Federal Reserve extended an $85 billion loan to American International Group to be paid back as AIG sells off some business in the biggest government takeover so far in the ongoing credit crisis. The deal is designed to let the Fed unwind AIG's hugely complex business in an "orderly manner, with the least possible disruption to the overall economy." The government will take a 79.9 stake in the firm, along with the right to suspend dividends.

The terms for lending are steep—the Libor overnight rate banks lend to each other, plus an extra 8.5 percent—and will last for two years. Robert Willumstad, AIG's CEO, will be replaced by Edward Liddy, former chairman of Allstate Corp.

AIG's plummeting stock price and Monday evening's credit downgrade by Moody's and Standard & Poor's sealed the fate of what was the nation's largest insurer. Ultimately, AIG went under because of its massive $441 billion exposure to credit default swaps (ironically, the instruments used to insure against default on assets like subprime mortgages).

It's not clear if the Fed's move was a last resort following reports that the government was trying to arrange a $70 billion to $75 billion private loan from Goldman Sachs and JPMorgan Chase. AIG also apparently rejected overtures from former chairman and CEO Hank Greenberg, who was angling for an investor-led takeover of the firm he ran for nearly four decades.

The announcement also explains the complacent nature of the Fed's decision at yesterday's meeting to leave interest rates unchanged.

Shares in Asian markets were up a bit on the news, and U.S. shares are expected to follow today. Whether gains are sustainable will depend on the Fed, AIG, and the ability of financial sector participants to unwind a player that has reach at least as wide as that of the Fed's last bailout, Bear Stearns.

My take: The deal should reassure investors worrying over an untold amount of counterparty risk in the financial system and comfort the market, given the government's guarantee that AIG won't default. That's the good news. The downside is we still don't know how to value the CDS and mortgage securities that got us into this mess in the first place. Also, with AIG's bailout coming just two weeks after the government takeover of Fannie Mae and Freddie Mac, it's still not apparent that credit markets are recovering. Further out, taxpayers are now on the hook for a few more of Wall Street's bad bets (though AIG will very likely pay off much of the balance), and the Fed's unprecedented help could result in a coming wave of equally unprecedented regulation of the financial services industry. Markets may surge today, but Wall Street will be in uncharted territory for some time.