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Fed to Loan A.I.G. $85 Billion in Rescue

Posted by Yogesh on Wednesday, 17 September, 2008

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 the troubled insurance giant American International Group, according to people briefed on the negotiations.

The decision, only two weeks after the Treasury took over the 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 A.I.G. failed to get a bank loan to avoid bankruptcy, Treasury Secterary Henry M. Paulson Jr. and the 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 p.m. with Mr. Paulson and Mr. 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 A.I.G. and other institutions does business with.

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s its role as an enormous provider of financial insurance, which effectively requires it cover losses suffered by other institutions in the instance of defaults of securities that they have purchased. That means A.I.G. is potentially on the hook for securities that were once considered safe.

If A.I.G. 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 A.I.G.’s possible collapse, reacted with relief to the news of the bailout. In anticipation of a deal, stocks about 1 percent in the United States on Tuesday and were up about 2 percent in early trading in Asian markets Wednesday morning.

Still, the move will likely start an intense political debate during the presidential election campaign over who is to blame for the financial crisis that prompted the rescue.

Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, said Mr. Paulson and Mr. Bernanke had not requested any new legislative authority for the bailout at Tuesday night’s meeting. “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,’ “ Mr. 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 Mr. 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. 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 A.I.G. came on the same day that the Fed 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 to A.I.G., 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 A.I.G.

Another reason that A.I.G. 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 A.I.G. ’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.Source  NYTimes.com

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One Response to “Fed to Loan A.I.G. $85 Billion in Rescue”

  1. britishpolitics said

    I don’t think the Fed has a choice because the ramifications if they had not intervened, the impact would have been felt around the world. When the financial markets have settled down, there needs to be a period of reflection and if necessary, more regulation and oversight in the this sector.

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