AIG Bailout Means Drastic About-Face for Feds

Fears of widespread economic fallout forced govt. to step in with $85B loan.

September 17, 2008, 8:31 AM

Sept. 17, 2008— -- Hoping to avoid a worldwide financial meltdown, the U.S. government last night took the unprecedented step of loaning insurance giant American International Group, or AIG, $85 billion in exchange for a shocking 80 percent ownership in the company.

The move was a stark about-face for regulators, who just days ago resisted pleas from AIG for help, and was the latest in a stream of massive government bailouts for financial firms that bet wrong on the subprime housing market.

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Stocks started the day down sharply, with the Dow Jones industrial average off by about 200 points. In the end, the Dow lost about 450 points with investors clearly upset with the financial sector.

The AIG takeover comes less than two weeks after the government assumed control of mortgage giants Fannie Mae and Freddie Mac, an act that backed mortgages with $200 billion of taxpayer money. That is in addition to the $29 billion the government pledged in March to back J.P. Morgan Chase's fire-sale purchase of Bear Stearns.

To pay for all these bailouts, the Treasury announced this morning that is will be issuing a special series of Treasury bills, separate from its normal borrowing programs.

AIG is the world's largest insurance company, with more than 74 million customers around the globe. It provides coverage for everything from cars to homes to planes, in addition to offering life insurance policies and annuities.

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But that is not where AIG got into trouble. The company's downfall comes from a decision to insure investments in the subprime market. As subprime mortgages started to default, AIG was on the hook to pay out more money than it had ever expected, and it didn't have enough cash on hand to continue operating.

"They called it insurance, but they were gambling," said Nobel Prize-winning economist Joseph Stiglitz. "In a market economy, there has to be a sense of accountability. You can't come running to the government every time you have a problem."

Stiglitz, co-author of The Three Trillion Dollar War, said these bailouts are "a damning condemnation of the way we've managed our economy and regulation system" and that it's time to "draw a line."

In the short term, he said, it will be hard to let these companies fail, but "we will end up with a financial system that will probably be stronger" in the end.

But many others said that AIG was simply too big to fail and that its demise would send shockwaves throughout all corners of the economy.

Former AIG Chief Executive Maurice R. "Hank" Greenberg told Chris Cuomo on "Good Morning America" today that "it's in our national interest to keep this company alive."

A Massive Bailout

"It really isn't a gift to AIG or its shareholders," Greenberg said. "This is a loan. Interest is going to be paid."

Greenberg, who spent nearly 40 years at the helm of the company, said that after he left, "all the risk-management procedures we had in place were dismantled."

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Holders of AIG insurance or annuities with the company are protected by various state regulations.

"The insurance policies written by AIG companies are direct obligations of its regulated subsidiary insurance companies around the world," the company said in a statement. "These companies are well capitalized and meet or exceed local regulatory capital requirements. The companies continue to operate in the normal course to meet obligations to policyholders. In particular, AIG noted its long tradition of service in Asian markets, which are key to AIG's future growth."

Virtually every Fortune 500 company does business with AIG. Let's say you are a toymaker. To protect your company from liability suits -- maybe a defective toy that ends up choking toddlers -- you take an insurance policy.

If AIG went bankrupt, the fear of regulators was that nobody will rise up to fill its shoes. That means that major companies around the world wouldn't have insurance and be protected from the normal risks of doing business. So that toymaker might decide to stop production of its toys because the risk would be too great. Airlines might decide to stop flying because nobody was insuring their planes. The impact would ripple throughout the world.

And yet some say the government's bailout still won't be enough to save AIG.

"AIG is now a walking-dead company," said Peter Boockvar, an equity strategist at the trading firm Miller Tabak & Co. "Who is going to want to do business with AIG?"

This latest bailout renews the debate over how far the government should go to save companies that make risky decisions and lose. The so-called moral hazard argument says that if companies know the government will save them, they are more likely to engage in risky behavior.

The Bush administration sent a clear message over the weekend that it wouldn't just bail out any company when it decided not to aid Lehman Brothers, the nation's fourth largest investment bank. After the faltering firm failed to find a buyer over the weekend, it filed for bankruptcy Monday morning.

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke were explicit: There is no political will for yet another government bailout.

Too Big to Fail

Speaking at the White House Monday, Paulson said he "never once" considered it appropriate to use taxpayer dollars to help save Lehman, which he considered a different case from Bear Stearns.

But in the end, AIG's $1 trillion in assets and more than 116,000 employees was just too much to let go under.

The Federal Reserve said in a statement last night that it had determined that "in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance."

Sen. Chris Dodd, D-Conn., chairman of the Senate Banking Committee, asked the Bush administration "to become much more aggressive about addressing the root cause of this entire economic crisis -- namely, the foreclosure crisis. Only when foreclosure rates start to drop significantly will we see home prices begin to level out and our markets regain much-needed stability."

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The financial system is far from out of the woods.

Focus has now shifted to Washington Mutual, the country's largest savings and loan. Could it now be also called too big to fail?

The company's stock has plummeted in the last two weeks as investors worry that the bank has too many bad mortgages and loans on its books.

Troubles at WaMu

The bank has seen a doubling of defaults and has many outstanding adjustable-rate mortgages that are due to reset to a higher, harder-to-pay rate shortly. In July, WaMu reported a $3.3 billion loss for the second quarter. Since April, the bank's share price has plummeted about 75 percent from $13.15 to around $2.

It has not been a good year for banks. So far, 11 banks have failed and had to be taken over by the Federal Deposit Insurance Corp., or FDIC, the largest being IndyMac.

To put that in perspective, there are nearly 8,500 banks nationwide covered by the FDIC.

But all it takes is one big failure to throw the system into turmoil. So far -- with the exception of IndyMac -- this year's failures have been small, regional banks with minimal impact on the overall economy.

If Washington Mutual goes under, most customers would be protected by the FDIC insurance. But such a failure could wipe out the remaining balance in the bank-funded FDIC insurance pot. If that were to happen, the FDIC would turn to the U.S. Treasury for more cash to protect depositors. Individuals with money in troubled banks would, for the most part, be safe but taxpayers could end up footing the bill to protect those deposits.

The AIG Bailout Details

The loan to AIG will be available for two years at a current interest rate of 11 percent. AIG can use the money to meet any of its financial obligations and it is expected that the loan will most likely lead to the company selling off certain parts of its business, without further upsetting already fragile financial markets.

The loan will be secured through assets AIG currently holds and the U.S. government will receive nearly 80 percent of stock in AIG.

Current management of the company will be replaced, though the board of directors will stay in place for the time being. But the board's power may be limited, as the federal government now has veto power over important decisions such as which divisions to sell, what companies to buy and whether dividends should be paid.

With reports from Alice Gomstyn

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