AIG Rescue at Hand: Government to Take 80% Stake in Exchange for $85 Billion

An $85 billion government rescue of insurer American International Group Inc. looked increasingly likely Tuesday to stave off a bankruptcy that would have thrown world markets back into turmoil.

The Federal Reserve will extend AIG $85 billion in exchange for a nearly 80 percent stake to bail out the troubled insurance giant, a person briefed on the matter said.

The deal would avoid the biggest corporate bankruptcy ever and follows a government bailout of mortgage lenders Freddie Mac and Fannie Mae just over a week ago.

Earlier, U.S. stocks clawed back from their biggest one-day drop in seven years, soothed by speculation about a government rescue of AIG, a likely sale of Lehman Brothers’ investment bank to Britain’s Barclays, and a better-than-expected quarterly profit from Goldman Sachs.

Morgan Stanley added a positive note after the close of trading when it reported a slight quarterly profit fall, setting it apart from rivals bleeding red ink.

Then AIG shares, which had sunk 21 percent in regular trading, fell as much as 48 percent in after-hours dealings after reports of a rescue that could wipe out shareholders.

The New York Times, which had reported that AIG could file as soon as Wednesday for bankruptcy protection, later reported the deal with the Fed.

“This would mean another shareholder wipeout,”said David Ader, head of government bond strategy at RBS Greenwich Capital in Greenwich, Connecticut.

Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson were briefing members of Congress on the deal Tuesday evening, a Treasury official told Reuters.

“They’re too big to fail. AIG touches too many people and too many companies globally, and it would be much more of a disorderly event if it went bankrupt than it was with Lehman,” said Anton Schutz, president of Mendon Capital in Rochester, New York.

The developments overshadowed an earlier Fed decision to keep interest rates unchanged.

U.S. stocks overall surged at the end of a volatile session, with the Dow Jones industrial average gaining 1.3 percent. Dow futures gained an additional 0.5 percent after news of the AIG bailout.

“CATASTROPHIC PROBLEM”

In a sign of how much U.S. authorities have been trying to prop up the markets, the Federal Reserve Bank of New York took the unusual step of providing some $87 billion in financing to Lehman units to prevent disruption as customers flee.

Banks’ cost of overnight borrowing surged above 10 percent, signaling extreme distrust among the institutions. That’s about five times the typical level, given that the Federal Reserve’s target for short-term rates now stands at 2 percent.

The two rates typically track each other. Overnight dollar deposit rates eased later, but were still at high levels.

Hours before Lehman’s creditors were set to have their first formal meeting post-bankruptcy, there was a glimmer of hope for some of its roughly 26,000 employees.

Barclays agreed to pay $2 billion to buy Lehman’s core U.S. broker-dealer business, including equity, fixed income, M&A advisory, a person familiar with the matter said.

A potential bankruptcy filing by AIG could have a market impact of $180 billion, or 50 percent of total capital raised by financial institutions worldwide since the beginning of the credit crunch, according to one estimate.

Worries about the health of AIG, until recently the world’s biggest insurer by market capitalization, spread to other asset classes.

Some firms ceased making markets in commodity securities backed by matching contracts from AIG on Monday afternoon, ETF Securities said. The affected securities are known as exchange-traded commodities (ETCs).

Earlier, New York Governor David Paterson told CNBC that the insurer had “a day” to solve its problems. A failure would result in a “catastrophic problem” for the market, said Paterson, whose administration oversees regulation of AIG.

AIG CONTRACTS AT STAKE

Both Moody’s and Fitch Ratings cut AIG’s rating by two notches on Monday, while Standard & Poor’s Rating Services lowered its rating by three pegs.

The downgrades meant that AIG’s trading partners can require the insurer to post an additional $14.5 billion in collateral, according to an Aug. 6 regulatory filing.

They could also result in the early termination of some contracts, requiring an additional $5.4 billion in payments, the filing showed.

“You don’t just have a potential impact on the reinsurer side, you have it on the institutions that might be holding AIG paper,” said Lorraine Tan, director of research for Asia at Standard and Poor’s in Singapore.

“This would have a much bigger impact than a bank going down like Lehman or Bear (Stearns), or even a Wachovia (Corp.) or WaMu in the U.S. AIG has a much bigger presence globally.”

(Reporting by Lilla Zuill and Jonathan Stempel; Editing by Jack Reerink and Ted Kerr)