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U.S., in shift, agrees to bail out AIG in bid to avert disaste

New York Times News Service

WASHINGTON — Acting to avert a possible financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government an ownership stake in troubled insurance giant American International Group, according to people briefed on the negotiations.

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.

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What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but AIG’s its 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.

Rep. Barney Frank, D-Mass., the chairman of the House Financial Services Committee, said Paulson had not requested at Tuesday night’s meeting, and did not appear to need, any new legislative authority for the bailout.

"The secretary and the chairman of the Fed, two Bush appointees, came down here and said, ‘We’re from the government, we’re here to help them,"’ Frank said. "I mean, this is one more affirmation that the lack of regulation has caused serious problems. That the private market screwed itself up and they need the government to come help them unscrew it."

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.

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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.

The decision to rescue AIG came on the same day that the Federal Reserve decided to leave its benchmark interest rate unchanged at 2 percent, turning aside hopes by many on Wall Street that the Fed would try to shore up confidence by cutting rates once again.

Fed and Treasury officials initially had turned a cold shoulder on 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.

But 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.

Another reason that AIG posed systemic risk is that it might have been forced to liquidate real estate and other assets at fire sale prices - a move that could drive property prices lowers and force countless other companies to mark down the value of their own holdings.

The complexity of AIG ’s business, and the fact that it does business with thousands of companies around the globe, make its survival critical at a time when there is stress throughout the financial system worldwide.

"It’s the interconnectedness and the fear of the unknown, meaning the impact of a failure," said Roger Altman, a former Treasury official in the Clinton administration. "But size is a factor; you can’t ignore that. The prospect of world’s largest insurer failing, together with the interconnectedness and the uncertainty about the collateral damage - that’s why it’s scaring people so much."

AIG is a sprawling empire built by Maurice "Hank" Greenberg, who acquired hundreds of businesses all over the world until he was ousted amid an accounting scandal in 2005. Many of AIG’s subsidiaries wrote insurance of various types. Others made home loans and leased aircraft. The diverse array of companies were more valuable under a single corporate parent like AIG, because business cycles offset other, giving AIG a relatively smooth stream of revenue and income.

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After Greenberg’s departure, AIG restated its books over a five-year period and instituted conservative new accounting policies. But before the company could really rebuild itself, it became embroiled in the mortgage crisis. Some of its insurance companies ended up with mortgage-backed securities on their books, for example.

But AIG’s downfall involved a new kind of insurance its financial products unit offered investors in complex debt securities.

Its stock tumbled faster this year as first the debt securities lost value, and then the derivatives-based insurance contracts came under a cloud.

The Fed’s extraordinary rescue of AIG underscores how much fear remains about the destructive potential of the complex financial instruments, like credit default swaps, that brought AIG to its knees. The market for such instruments has exploded in recent years, but it is almost entirely unregulated. When AIG began to teeter in the last few days, it became clear that if it defaulted on its commitments under the swaps, it could set off a devastating chain reaction through the financial system.

"We are witnessing a rather unique event in the history of the United States," said Suresh Sundaresan, the Chase Manhattan Bank professor of economics and finance at Columbia University. He thought the near-brush with catastrophe would bring about an acceleration of efforts within the Treasury and the Fed to put safety controls on the use of credit default swaps.

"They’re going to tighten the screws and say, ‘We want some safeguards on this market,"’ he said of the Fed and the Treasury. "Contagion risk is very high."

Most of AIG’s subsidiaries are considered healthy and stable, and there is little question about who regulates them. AIG’s crisis grew primarily out of its financial products unit, which dealt in complex debt securities and credit default swaps.

The swaps are not securities and are not regulated by the SEC. And while they perform the same function as an insurance policy, they are not insurance in the conventional sense, so insurance regulators do not monitor them either.

AIG’s complex debt securities had already lost billions of dollars in value in the months before the crisis began, because their value depends on home values. But in the last two days, the swaps that AIG’s financial products unit had sold began eating up billions of dollars of AIG’s cash and liquid assets. That ultimately paralyzed AIG, because it could not find a way to keep up with the fast-growing need to provide cash under the terms of its swap contracts. Nor was AIG able to reassure investors and customers by telling them how long the cash calls would go on or how big they might get. The swaps run for about one year.

That spelled catastrophe for AIG, but it also threatened all the countless investors and other entities that had entered into AIG’s swap contracts.

When AIG sold the swaps, it committed itself to make the purchasers of debt securities whole in the event of a default. That made the debt securities more valuable to the investors who bought them.

But if AIG suddenly became unable to honor its swap commitments, its counterparties would lose too, because the securities they were holding would no longer be insured, and thus lose value.

"Suddenly banks would be holding a lot of bond-like instruments that were no longer insured," Sundaresan said. "They would have to mark them down. And when they marked them down, they would require more capital. And then they would have to go out and raise capital in these markets, which is very difficult."

Sundaresan said for a new market arrangement to succeed, it would have to create a clearinghouse to track swaps trading, and daily requirements to post collateral, so that a huge counterparty would not suddenly find itself having to come up with billions of dollars overnight, the way AIG did.

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