Fed Steps in and Bails Out AIG to the Tune of $85 Billion in Taxpayer Funds

By , Money Morning •

By Jennifer Yousfi
Managing Editor

In a stunning reversal, the U.S. Federal Reserve offered American International Group Inc. (AIG) access to $85 billion in exchange for a 79.9% stake in the largest domestic insurer.

After AIG shares were violently whipsawed in the market, first on reports of a possible bridge loan, then later on reports that the $40 billion emergency loan request from the government had been denied, representatives from the Fed and U.S. Treasury Department met to discuss the fate of the insurer deemed by many "too large to fail".

"The administration is approaching an unprecedented step, but unfortunately we are living in unprecedented times. Hearing of these plans, you have to stop to catch your breath. But upon reflection, the alternatives are much worse," said Sen. Charles Schumer, D-N.Y., The Associated Press reported. 

AIG is a holding company with operations in over 130 countries, mainly focused on insurance and retirement planning. While many of AIG's subsidiaries remain sound and profitable, the corporate holding company was facing a liquidity crunch due to bad bets on billions in credit-default swaps (CDS) sold to protect subprime credit derivatives.

The global effect of a potential AIG collapse would be far-reaching and affect scores of businesses as well as many consumers.

In statement released at 9:00 p.m. EDT Tuesday night, the Fed outlined the emergency bailout of AIG.

"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's statement read.   

AIG shares sank further yesterday (Wednesday) as the market digested the latest government bailout. AIG stock dropped another $1.70, a decline of 45%, to close at $2.05 in New York. The shares are down 45% year-to-date and well off their 52-week high of $70.13.

As a component of the Dow Jones Industrial Index, AIG's heavy losses weighed on the index bringing it down 449.36 points, a decline of 4% to close at 10,609.66.

The Fed's deal left AIG shareholders out in the cold as dividends will likely be halted, but with its credit ratings slashed and desperate to raise capital, the AIG board of directors had little choice but to agree to the offer.

"AIG is a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues," the AIG board said in a statement released after the Fed's announcement. "We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis."

Under the new provision, AIG will have access to $85 billion in funds over the course of 24-months. The funds are repayable at a rate of three-month Libor – London Interbank Offer Rate – plus 850 basis points, which is currently about 11.3%.

The "punitive" interest rate on the two-year loan "makes it extremely clear that this is not a subsidy extended to keep the company afloat but rather a stranglehold that makes AIG unviable while ensuring that its obligations will be met," Marco Annunziata, an analyst at UniCredit SpA, wrote in a note to clients, Bloomberg News reported. "This is to all extents and purposes a controlled bankruptcy."

In addition, the Fed reserves the right to make senior management changes. The Wall Street Journal reported that AIG Chief Executive Officer Robert Willumstad has been asked to step down and will be replaced by Edward Liddy, formerly of Allstate Corp.

Willumstad had only been CEO for a brief three months, and yet, he is eligible to walk way with a golden parachute valued at $7 million.

"To most people, that would seem to be a lot of money, given he was only there a few months," David Schmidt, a senior consultant at New York-based executive pay firm James F. Reda & Associates, told Bloomberg. "I'm sure when they negotiated this contract they never thought he'd only be there three months."

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