Treasury to give AIG another $40 billion

— -- The Federal Reserve and Treasury Department Monday upped the stakes in the government's role in American International Group to more than $150 billion with a restructuring of its loan package that includes $40 billion in new funding from the financial rescue package and other measures to help the ailing firm.

The changes will "keep the company strong and facilitate its ability to complete its restructuring process successfully," the Fed said in a statement. "These new measures establish a more durable capital structure, resolve liquidity issues, facilitate AIG's execution of its plan to sell certain of its businesses in an orderly manner, promote market stability, and protect the interests of the U.S. government and taxpayers."

Among the changes:

• The Treasury Department will purchase $40 billion of newly issued AIG preferred shares. The purchases will be funded under the $700 billion Troubled Asset Relief Program passed by Congress. The Fed is cutting a previously announced loan to AIG to $60 billion from $80 billion because of the Treasury's involvement.

• The Fed is reducing the interest rate on its loans to AIG by 5.5 percentage points. The loans now carry a rate of 3 percentage points plus the going rate for the three-month London Interbank Offered Rate, the rate large banks charge each other for short-term unsecured loans. The length of the loans will now be five years vs. the previous two.

• In a new program, the Fed will lend up to $22.5 billion to a newly formed limited liability company to fund the firm's purchase of residential mortgage-backed securities from AIG's U.S. securities portfolio. AIG will make a $1 billion loan to the LLC and bear the risk for the first $1 billion of any losses. The loans will be repaid from the cash produced by the assets as well as proceeds from any sales of these assets. A previously announced $37.8 billion program established by the New York Fed in October 8, will be repaid and ended because of the new program.

• In a second new program, the Fed will lend up to $30 billion to a newly formed LLC to fund the LLC's purchase of collateralized debt obligations, which are securities that package together mortgage and other debt and are sold to investors. AIG will make a $5 billion loan to the LLC and bear the risk for the first $5 billion of any losses.

The Treasury had already allocated $250 billion of the $700 billion to inject cash into banks and said it was considering buying stakes in other firms. Other industries, including the auto manufacturers, are asking for aid from the program.

One problem AIG has grappled with is assets that are eroding in value just as it was trying to unload them to pay off the government's loan.

"In the rush to put together the original program, the government underestimated the likelihood of worsening economic conditions and the impact that eroding assets would have on AIG," says Joshua Rosner, managing director at Graham Fisher & Co., an investment research firm.

The Federal Reserve in mid-September said it would provide AIG with an $85 billion emergency loan, putting the government in control of the flailing insurance giant. Less than a month later, the Fed added another $37.8 billion to the deal, borrowing investment-grade, fixed-income securities from AIG in return for cash collateral.

The loan has come under scrutiny from lawmakers who criticized AIG after it was discovered that the insurance company spent $443,000 on a week-long event, which included spa services, for agents at a California resort less than a week after the initial package was announced.

The Treasury Department in a statement said AIG would be subject to limits on executive compensation under the financial rescue package. "AIG must comply with the most stringent limitations on executive compensation for its top five senior executive officers," the department said. "Treasury is also requiring golden parachute limitations and a freeze on the size of the annual bonus pool for the top 70 company executives."

As the Fed and Treasury were announcing its plan, AIG reported its earnings for the third quarter. The firm said it had a net loss of $24.47 billion or $9.05 per diluted share compared to the previous year."

Third quarter results reflect extreme dislocations and volatility in the capital markets and significant charges related to restructuring activities," AIG chairman and CEO Edward M. Liddy said in a statement. "Reported earnings are not indicative of the underlying core earnings power of our insurance businesses, which remain solidly capitalized. Retention of our customers remains strong."

California State University economics professor Sung Won Sohn says the government continues to prop up AIG because the consequences of the company's failure are too dire.

"AIG has extensive reach not only in the United States, but in 100 countries," he says. "If AIG were to go down, this would create turmoil around the world."

Plus, Sohn notes that AIG actually has assets that are likely to increase in value.

"I expect (the government) to make money, not lose money," Sohn says.

Contributing: Kathy Chu