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US Fed rides to the rescue of AIG with $85bn bail-out

The nationalisation of America's biggest insurance company, AIG, added to the considerable strain on global debt markets yesterday and left the United States government struggling to reassure traders that its $85bn (£47bn) loan would be enough to restore health to the company and to the credit derivatives market in which it is a pivotal player.

The Federal Reserve extended the unprecedented bridge loan to AIG on Tuesday night, but imposed a punitive interest rate, and the federal government took a 79.9 per cent stake in the company. The actions effectively confirmed to the markets what many influential voices had been saying: that AIG's $440bn of credit insurance is too important to financial institutions across the world and that its failure would be too destabilising to risk.

It also brought an extraordinary end to the independence of a proud company that had been the world's biggest insurer until the credit crisis unfolded, a company best known for its mundane general insurance and life insurance businesses, that was overwhelmed and ultimately destroyed by its high-risk foray into an unregulated corner of the debt markets.

It was an end that left its former chairman Hank Greenberg raging to all who will listen that his successors destroyed his legacy. The one-time US army captain, who fought at D-Day in the Second World War, revolutionised the insurance industry by relying on insurance profits rather than investment returns to make money, although the company was also known for its aggressive business practices and its racy accounting. He turned a sleepy insurance company founded in 1919 in Shanghai into a global powerhouse during his 38 years at the helm. Since 2005, though, he has been in legal skirmishes with the company, after being forced out as the price of resolving an accounting scandal. He and his personal investment firms have lost almost $6bn on their remaining AIG shareholding this month alone. His spokesman said it had wiped out his fortune.

Under Treasury supervision, the company will most likely be broken up, with the sale of its ring-fenced insurance businesses around the world providing cash to pay back the loan as soon as possible. The fate of its credit insurance business – the seat of its problems – remained up in the air yesterday, with credit markets gummed up in the short term and with its long-term liabilities impossible to quantify. Its credit default swaps insure $440bn of bonds, including many linked to the value of mortgages, which have been in freefall due to the US housing market crash.

AIG's credit rating downgrade, the crisis of confidence among its customers and the turmoil in the credit markets since the collapse of Lehman Brothers at the weekend all make it difficult to predict whether the $85bn will be enough to cover calls for more collateral and other obligations.

A deal was wrapped up in a single day of frantic negotiations between the Treasury, the Fed and insurance regulators, along with AIG and its advisers. Until Tuesday morning, the government had been insisting that AIG find a private solution to its woes, but no solution was available. The U-turn came after Treasury models showed a potentially disastrous impact on the credit default swaps market if one of its biggest players were to be frozen by bankruptcy proceedings.

The Federal Reserve said "the 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".

Eric Dinallo, the insurance superintendent in New York, which regulates some AIG subsidiaries, said participants had also been mindful of the scenes in Asia and news from elsewhere showing customers of AIG subsidiaries – most of whom would have been protected under local regulations – clamouring to withdraw their business from the company. There would have been a "continued degradation of confidence" if a deal had not been done quickly, Mr Dinallo said, and otherwise robust subsidiaries could have become too weak to sell to cover losses in the financial business.

The White House defended the bail-out, saying it was done to protect other companies. But it takes the Fed and the Treasury into risky territory. Yesterday morning, the Treasury said it would raise $40bn in new government debt to top up the Fed. The central bank has already exchanged more than $200bn of its reserves of Treasury bills for riskier collateral as it tries to restore liquidity to the banking system.

By keeping its stake in AIG below 80 per cent, as it did when it nationalised mortgage giants Fannie Mae and Freddie Mac 10 days earlier, the US government will be able to keep the company's finances off its accounts. But pressure is building on the pristine triple-A credit rating of the US government, the chairman of Standard & Poor's sovereign ratings committee said. The bail-out "has weakened the fiscal profile of the United States", John Chambers said. "There's no God-given gift of a triple-A rating, and the US has to earn it like everyone else."

The cost of insuring 10-year US Treasury debt against default rose yesterday to a record high. However, Mr Chambers said the outlook for the rating remained stable and the lack of government action could have made matters worse.

How do credit default swaps work?

You've got a car. You pay AIG £200 a year and it promises to pay the £2,000 repair bill should you run it into a wall. Makes sense.

You've got every hope of a long retirement. You pay AIG £100 a month and it promises to pay you a nice big lump sum when you eventually collect your carriage clock. Makes sense. You're a fund manager that invested in $50m of General Electric bonds.

You pay AIG $1m a year and it promises to pay you whatever you lose if General Electric were to default on that bond. That contract is called a credit default swap. You buy it from a broker, rather than direct from AIG, but it makes sense, too.

There are $62 trillion of outstanding CDS contracts, covering everything from those easy-to-understand General Electric bonds to the impossible-to-understand mortgage derivatives that have exploded in Wall Street's face. For far too many banks and hedge funds, AIG's insurance was the last firewall between them and having to accept that their dodgy investments are worth vastly less than they've told everybody. If its $440bn of insurance became worthless, an untold number of financial institutions could have been in trouble.

It had been allowed to become too big to fail, and that makes no sense at all.