WASHINGTON | Acting to avert a possible financial crisis worldwide, the Federal Reserve late Tuesday agreed to an $85 billion bailout to rescue troubled insurance company American International Group.
The decision, only two weeks after the Treasury took over Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.
In return for the loan, the government will receive nearly an 80 percent stake in American International Group, commonly known as AIG. This essentially makes Uncle Sam the owner of the $1 trillion company.
Taking such a huge stake in a large, international company has few precedents. Just last weekend, the administration had flatly refused to risk taxpayer money to prevent the collapse of Lehman Brothers.
But the central bank on Tuesday came to the conclusion that AIG was too big to fail.
Earlier in the day, the Fed defied predictions that it would cut interest rates amid the ongoing credit crisis; instead, the Fed left its benchmark lending rate unchanged at 2 percent.
Many economists had forecast the Fed would reduce rates by at least a quarter of a percentage point in order to bolster confidence in financial markets, which have been roiled by the bankruptcy earlier this week of Lehman Brothers and the sale of Merrill Lynch.
But what spurred Fed and Treasury officials into bailout action Tuesday night was not simply the prospect of another large corporate bankruptcy, but AIG’s role as an enormous provider of financial insurance. The company covers losses suffered by other institutions in the instance of defaults of securities that they purchased. This meant AIG would be potentially on the hook for securities that once were 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.”
Fed and Treasury officials initially had turned a cold shoulder on AIG, when company executives pleaded on Sunday night for 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 had turned sour.
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 lower and force countless other companies to mark down the value of their own holdings.
AIG’s downfall involved a new kind of insurance its financial products unit offered investors in complex debt securities.
The Fed’s extraordinary rescue of AIG underscores how much fear remains about the destructive potential of the complex financial instruments, such as credit default swaps, that brought AIG to its knees. Credit-default swaps allow buyers to insure securities backed by mortgages. The market for such instruments has grown tremendously in recent years, but it is almost entirely unregulated. When AIG began to teeter in the past 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.
In the past two days, the swaps that AIG’s financial products unit had sold began eating up billions of dollars of cash and liquid assets. This 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.
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. This 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 because the securities they were holding would no longer be insured and, thus, lose value.
The Fed’s interest rate decision earlier Tuesday took some by surprise on Wall Street, where boos rained down at the New York Stock Exchange as the announcement was made.
As recently as Friday, the market had expected the Fed to leave rates unaltered.
On Monday, the betting line shifted sharply toward a rate cut as investors absorbed the message that the government will not bail out every struggling financial firm, effectively triggering a series of events that reshaped the investment banking business. Those concerns drove the Dow Jones industrial average down 504 points, its biggest one-day drop in seven years.
Wall Street sent shares tumbling more than 100 points immediately following the Fed announcement Tuesday, but stocks quickly recovered, closing up 141.51 points, or 1.3 percent.
Analysts reckoned that a rate cut would have done little to alleviate the ongoing credit crunch, which is more about the availability of credit than its price. They also interpreted the Fed’s inaction as a signal that policymakers don’t share Wall Street’s doom and gloom about the broader economy.
“Given the despair in the financial markets and the clearly weaker economic trends, I felt that a cut would have been justified,” said Mark Vitner, senior economist at Wachovia Corp.
“ … The economy has clearly slowed, but we’re not about to slip into the abyss,” he said. “When you talk to folks on Wall Street, they think the whole world is about to come to an end.” Gary Cloud, senior portfolio manager for Financial Counselors Inc. in Kansas City, said: “The resolution of AIG is far more important than a quarter-point or half-point cut in the Fed’s interest rate mix.”
Some analysts applauded the Fed’s move for its calming effect on jittery investors caught unaware by the weekend’s developments and anxious about the prospect of more bad news around the corner. “I was really thrilled with the Fed’s decision because a big rate cut would have signaled panic,” said Peter Cohan, a management professor at Babson College in Wellesley, Mass. “And a rate cut would not have had an effect on the fundamental problem but only made it worse.”
“Also, I think it will strengthen the dollar, whereas cutting rates would have weakened the dollar at a time when the strength of the dollar is very important.”
Richard Yamarone, director of economic research at Argus Research Corp., agreed and said in a written commentary that “the need to further prime the pump isn’t a legitimate policy prescription.” A rate cut, he said, “would only add fuel to the raging inferno in the markets.”
The New York Times, the Chicago Tribune, The Associated Press and The Star’s Dan Margolies contributed to this report.