Published September 18, 2008

Fed rescues AIG to save the world

Global insurance giant was just too big to be allowed to fail - it could have taken the US economy down with it

By ANDREW MARKS
NEW YORK CORRESPONDENT
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ON Tuesday, the US Federal Reserve Board authorised the New York Fed to loan American International Group (AIG) US$85 billion to stave off an imminent bankruptcy and keep the world's financial system from collapsing, and took the milestone step of essentially becoming the majority stakeholder in the world's largest private insurance company - a corporation whose underwriting and guarantees back hundreds of billions of dollars worth of securities around the globe.

In the chaotic world of unprecedented and extraordinary events that have defined Wall Street and the world's banking system the past seven months, a period that has witnessed the biggest corporate bankruptcies (Lehman Brothers) and rescues (Bear Stearns, Fannie Mae and Freddie Mac) in US history, the Fed's latest move to prevent a national and global debacle in the credit markets may be the most extraordinary and unprecedented event of all.

The loan will give the company, which sells insurance in more than 130 countries, time to sell its assets on an orderly basis, AIG said in a statement.

CEO Robert Willumstad, 63, will be replaced by former Allstate Corp CEO Edward Liddy, 62.

On Wall Street and in financial capitals around the world, investors and bankers breathed an initial huge sigh of relief, because of the fear that AIG's failure might very well have sent the Wall Street-born credit crisis - a debacle that has already wreaked enough financial destruction to bring down several of the world's largest investment banks and has thus far left 29 major financial institutions with a trillion dollars of losses - into outright collapse of the financial system.

'I'll tell you, that was a close one. We came to the brink of Armageddon with the prospect of AIG failing,' said one money manager who didn't want his name used. 'It would have been a real 'Black Monday' like the one had in 1987', when the Dow swooned 22.7 per cent, he said. 'The 'depression' word started getting tossed around as people contemplated what AIG's going under would do to the economy,' he added.

After taking a 79.9 per cent stake in the insurer that cost US$85 billion of US taxpayer money, the Fed said in a written statement: '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.'

But after Wall Street rallied on Tuesday afternoon as word spread of a government intervention to spare AIG, boosting the Dow to a 140 point, 1.4 per cent rebound from the latest 'Black Monday' sell-off, investors reversed course amid renewed concerns for the health of the financial system yesterday morning in New York, sending stocks tumbling once again.

In the first half-hour of trading on the NYSE, blue chips were down 234 points, or 2.12 per cent, to 10,824, wiping out Tuesday's gains and then some, as the spread between the three-month Treasury bill and the three-month Libor spiked to its highest level since the crisis began, indicating even tighter credit conditions. The S&P 500 was off 26 points, or 2.19 per cent, and the Nasdaq Composite was falling by 51 points, or 2.35 per cent.

'The problem for the financial markets now is liquidity and the willingness to lend. The Fed members obviously felt that keeping AIG afloat was crucial to keeping the markets stable. Over time, we'll start to see that stability return, but it's going to take a while,' said Joel Naroff, president of Naroff Economic Advisors.

Adding to the renewed feelings of panic was the late Tuesday news that the Reserve Primary Fund, the very first money market fund, became only the second money fund in history to fall below US$1 per share. 'That's a sign of market panic,' said Marc Pado, chief investment strategist at Cantor Fitzgerald. 'But I can only imagine how bad things would be today if the Fed had left AIG to fail. After (Treasury Secretary Henry) Paulson said they wouldn't use federal funds to bail out companies, to do just that for AIG only days later meant there was no other choice, and shows the depth of the problems they're looking at,' he said.

Analysts said that AIG - whose underwriting of billions of dollars worth of credit default swaps (essentially, insurance against default on assets tied to corporate debt and mortgage securities) alone made the insurer's survival crucial to the world financial system - would not have been able to meet new collateral requirements after being downgraded by credit rating firms. 'The sheer number of individuals and businesses that depend on this company is so monumental,' observed hedge fund manager and market commentator James Cramer, 'I think it's safe to say the whole financial world might seize up if AIG looked like it was going to go under.'

Mr Pado believes stocks will test the lows the Dow hit on Tuesday before stabilising. 'But this won't be a V-shaped recovery. There are still issues left out there for the market to worry over,' he said, noting concerns over the survival of Washington Mutual, the largest savings & loan in the US, and mortgage insurers Ambac and MBIA.

'Stocks will start to see improvement when the focus shifts to Q4, but for now people are looking at their personal wealth and seeing how, between the depressed housing market and now the stock market, it's getting hammered and that means it's going to be harder to see a recovery.'