WASHINGTON – Invoking extraordinary powers granted after the 1929 stock market crash, the government seized control of the insurance giant American International Group late Tuesday to preserve a crucial bulwark of the global financial system.
The move to lend the Wall Street giant up to $85 billion in exchange for nearly 80 percent of its stock effectively nationalizes one of the central institutions in the crisis that has swept through markets this month.
The government had sought to avoid federal intervention by lining up private companies to rescue AIG. But the effort failed when companies were unwilling to take on the massive financial risk, forcing the government’s hand.
AIG found itself on the verge of bankruptcy because of mounting losses from investments tied to subprime home mortgages and from the insurance it was providing to others who invested in mortgages.
When credit-rating agencies downgraded the company Monday, AIG suddenly faced a crunch to come up with $14.5 billion to meet its commitments. If the company failed, it could have set off cascading losses across the global financial system.
“The Board 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,” the Fed said in a statement.
“It’s heavy, heavy, heavy. It’s much more than has been done, except Fannie and Freddie,” said Sen. Charles Schumer, D-N.Y., who heads the Joint Economic Committee, referring to the mortgage finance giants Fannie Mae and Freddie Mac, which were taken over by the government earlier this month. “But when you look at the alternatives, none of them are better.”
Since years of loose mortgage lending caught up with the housing markets, spurring a decline in home prices and a wave of foreclosures, a contagion has spread through the financial system, infecting investors who bet on the bad debt. To contain the damage, the government has also intervened to prop up Fannie Mae, Freddie Mac and the investment bank Bear Stearns.
Treasury officials appeared to draw a line over the weekend when they allowed the Wall Street investment house Lehman Brothers to fail, sending a signal that other firms could not count on taxpayer help.
Government officials drew two distinctions between AIG’s situation and that of Lehman. First, since the demise of Bear Stearns in March, the government and private firms had been drawing up contingency plans for easing the collateral damage from a Lehman bankruptcy filing. AIG’s failure was a surprise – the company first went to the government for help Friday – and its sheer size and complexity made it impossible to quickly prepare for its collapse.
The other difference is that AIG does business in ways that get to Americans’ pocketbooks. Its short-term debt is held by institutions all over the world, including money-market mutual funds, and its overnight collapse could have caused big losses in those funds, perhaps even risking a run on them.
The possibility of a Fed rescue helped lift the Dow Jones industrial average more than 141 points Tuesday, to close at 11,059, recovering part of Monday’s dizzying 504-point drop.
The Fed, meanwhile, decided at a regularly scheduled policy meeting against cutting interest rates further, concluding that it was too soon to tell what effect the recent turmoil on Wall Street was having on the broader economy. The refusal to reduce rates was consistent with the Fed’s belief that measures to improve the functioning of the financial system – such as emergency loans to investment banks – should remain separate from actions that affect the overall economy.
AIG’s stock, which fell 61 percent Monday, plunged 75 percent more in early trading Tuesday but ended the day down 21 percent, or $1.01 a share, to close at $3.75 on trading volume of more than 1.1 billion shares.
On Monday, Treasury Secretary Henry M. Paulson Jr. – who had backed publicly funded bailouts of Bear Stearns, Fannie Mae and Freddie Mac – said he was reluctant to continue to use public funds to prop up individual firms. He left open the possibility that taxpayer funds could still be used broadly to “maintain the stability and orderliness of our financial system.”
But the clock ran out. At one point Tuesday, J.P. Morgan Chase and Goldman Sachs agreed to consider arranging a $75 billion loan to AIG that would be syndicated, or sold in pieces to other parties, to help spread the risk. But the firms walked away from that proposal after it became clear they would not be able to raise such a large amount in time, especially in such a troubled market, according to a person familiar with the negotiations.
Paulson and Fed Chairman Ben Bernanke were on Capitol Hill on Tuesday night, briefing congressional leaders on the government’s plans. The deal gives the government broad powers to force the sale of assets, cancel dividend payments to shareholders and replace the chief executive. Former Allstate chief executive Edward Liddy will succeed Robert Willumstad as AIG’s chief, according to a person familiar with the decision. The sources spoke on condition of anonymity because they were not authorized to speak publicly.
The company would be put up as collateral for the two-year loan. AIG’s state-regulated insurance subsidiaries would continue operating as normal in the immediate future, though they may eventually be sold to pay the government loan. The deal puts taxpayer money at risk for AIG’s troubled investments. But because the government can control the timing of asset sales, it may be able to profit from its intervention by holding out for better prices.
White House spokesman Tony Fratto said the president supports the deal. “These steps are taken in the interest of promoting stability in financial markets and limiting damage to the … economy,” Fratto said.
The Fed is using the emergency authority it was granted during the Great Depression. By law, the Fed can lend money to any individual, partnership or corporation in unusual and exigent circumstances, when the borrower cannot access funds in other ways. The power had not been exercised until March, when the Fed used it to rescue Bear Stearns.