AIG Worries Wreak Havoc on Financial Markets

U.S. financial markets saw wide swings today as investors contended with the fallout from Monday's 500-point drop in the Dow Jones industrial average, concerns about insurance giant AIG and news that the Federal Reserve would not cut interest rates.

By the close of the markets, the Dow Jones industrial average had rallied by more than 140 points after seeing three-digit drops earlier in the day.

Overseas markets in Europe and Asia, meanwhile, have seen sharp declines today, with one trader calling the scene a "bloodbath." The Hong Kong market dropped 5.4 percent while the South Korea's Seoul Composite Index plunged more than 6 percent.

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"Even if the Fed takes a more aggressive stance to resolve this crisis, we may see a brief rebound but it's inevitable that we are going towards a prolonged credit crisis period," said Lee Young-won, a strategist at Prudential Investment & Securities.

Asian markets began dropping shortly after both Moody's and Standard & Poor's announced late Monday night that they were lowering AIG's credit ratings, something the insurance company was desperate to avoid.

AIG is just the latest financial institution to find itself on the ropes.

In its struggle to raise capital, AIG, one of the largest insurance companies in the world, is reportedly seeking help from everyone from billionaire investor Warren Buffett to the Federal Reserve. Last month, the company posted a $5.4 billion loss for the second quarter, and this month, its stock price has dropped nearly 70 percent.

"Their liabilities are piling up, and their net worth doesn't sustain it," said Peter Boockvar, an equity strategist at the trading firm Miller Tabak & Co.

An AIG spokesman declined to offer comment about the general health of the company.

Boockvar said that he wasn't sure AIG would be able to survive against odds that include downgrades by credit rating agencies. "Many people won't use an insurance company if they're not triple-A, so you're going to get policies pulled from them and canceled left and right, and that's their bread-and-butter business," Boockvar said.

Though AIG is an insurance company -- its products include auto and life insurance -- the root of its problems lies in the same mortgage crisis that wreaked havoc on the health of investment banks Bear Stearns, which shut down last spring, and Lehman Brothers, which filed for bankruptcy protection this week.

While Bear Stearns and Lehman invested in mortgages, AIG sold insurance contracts -- known as credit default swaps -- to investors to protect them from losses stemming from mortgages that fell into default. With home after home going into foreclosure and the mortgage meltdown in full swing, AIG has had to make good on its insurance guarantees.

That's what has landed the company in hot water, Boockvar said.

"The models that they used never were stress-tested for the scenario we're experiencing now," he said.

The mortgage meltdown of today, Boockvar said, is the equivalent of "a 100-year flood."

Saving AIG

Some say that if AIG is on the brink of failure, the federal government, which this week declined to offer a bailout for Lehman Brothers, would have to step in and save the insurance giant.

They argue that the repercussions for the rest of the financial sector -- a number of financial firms trade with AIG -- would be too great if the company, which has more than 100,000 employees, were allowed to fail.

"If there's a company that seems too big to outright fail, AIG would probably qualify on that score," said Mike Santoli, the associate editor of Barrons Magazine.

New York State has cleared the way for at least one lifeline to AIG, which is headquartered in New York City. New York Gov. David Paterson announced Monday that the state would authorize AIG to borrow up to $20 billion from its subsidiaries.

"The state of New York would like to take action on behalf of so many New Yorkers whose lives are affected by the fiscal plight of this company," Paterson said, calling AIG "a critically important business enterprise" in the state.

Meanwhile, several news outlets have reported that the Federal Reserve has asked financial firms Goldman Sachs and JPMorgan Chase to arrange at least $70 billion in loans to AIG.

Boockvar and others said that loans made to AIG now would amount to "bridge" loans that the company could rely on temporarily until it raises money by selling assets. The Wall Street Journal reported on Monday that the company was considering selling its domestic automotive business, its annuities unit and its aircraft-leasing arm.

"People know that given time, AIG can sell a lot of assets in order to improve their balance sheets," Boockvar said.

If none of the reported rescue strategies succeed, and AIG does fail, those who hold insurance policies with the company might find themselves out of luck, Santoli said.

"There's a remote chance that if AIG went down ... there's zero value for anybody," he said.

Consumer advocates, meanwhile, are warning AIG against raising policyholder premiums as a way to cover its losses.

"Consumers were already hit once by the collapse of the mortgage house of cards in the form of record home foreclosures. They should not have to pay again with higher insurance rates," said Carmen Balber of the California-based group Consumer Watchdog.

With reports from ABC News' Dan Harris and Joohee Cho.