Remarkable rescue of U.S. largest insurer, AIG

The U.S. government late Tuesday agreed to rescue insurer American International Group (AIG) with an $85 billion loan from the New York Federal Reserve in exchange for a nearly 79.9 percent stake in the nation’s largest insurer. The rescue came just two days after the government refused to save Wall Street icon Lehman Brothers, which filed for bankruptcy on Monday, and is the latest in a series of government and private sector steps that have remade the U.S. financial system.

The government's deal dilutes current shareholders by giving the government a 79.9percent stake in the insurance company, with the power to veto asset sales and payment of dividends to shareholders. The line of credit to AIG comes with steep interest rate of 3-month Libor plus 8.5percent. AIG has two years to pay back the loan, and is likely to sell assets. An eventual liquidation of the company is most likely, senior Fed officials said. But with the government loan, the company won't have to go through a tumultuous fire sale.

The effort was aimed to stave off a bankruptcy that many feared would spark a global financial chaos. A disorderly failure of AIG could have caused unprecedented global ripple effects since AIG has $1.1 trillion in assets and 74 million clients in 130 countries. AIG is a major player in the market for credit default swaps, which are insurance-like contracts that guarantee against a company defaulting on its debt. Also, it is a huge provider of life insurance, property and casualty insurance and annuities.

The bailout marks the most dramatic turn yet in an expanding crisis that started more than a year ago with the mortgage meltdown. The resulting credit crunch is now toppling not only mainstay Wall Street players, but others in the wider financial industry.

The insurer has been hit hard by the housing crisis and credit crunch because its sales of credit default swaps and its subprime mortgage-backed securities holdings. Its derivatives unit sold guarantees on mortgage-related securities known as collateralized debt obligations, or CDOs, using credit-default swaps. As house prices fall and the credit crunch deepens, the market for these CDO exposures is disappearing, forcing AIG to report big write-downs of the value of the credit default swaps by $14.7 billion, pretax, in the first two quarters of this year. It also has had to write down the value of its mortgage-backed securities. The company has lost more than $18 billion in the past nine months as it wrote down these exposures and has seen its stock price fall more than 91percent so far this year.

Shares of AIG plunged more than 40percent Wednesday after the government's takeover of the insurance giant failed to assuage investors' fears about its troubles or soothe broader concerns about the health of the financial markets.

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