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.

Suggested Topics
Life and Style
techCould new invention save millions in healthcare bills?
David Moyes gets soaked
sport Moyes becomes latest manager to take part in the ALS challenge
A meteor streaks across the sky during the Perseid Meteor Shower at a wind farm near Bogdanci, south of Skopje, Macedonia, in the early hours of 13 August
voicesHagel and Dempsey were pure Hollywood. They only needed Tom Cruise, says Robert Fisk
peopleEnglishman managed quintessential Hollywood restaurant Chasen's
Life and Style
food + drinkHarrods launches gourmet food qualification for staff
Arts and Entertainment
Michael Flatley prepares to bid farewell to the West End stage
danceMichael Flatley hits West End for last time alongside Team GB World champion Alice Upcott
ebooksAn evocation of the conflict through the eyes of those who lived through it
Life and Style
Horst P Horst mid-fashion shoot in New York, 1949
fashionFar-reaching retrospective to celebrate Horst P Horst's six decades of creativity
Members and supporters of the lesbian, gay, bisexual, transgender (LGBT) community walk with a rainbow flag during a rally in July
Life and Style
Black Ivory Coffee is made using beans plucked from elephants' waste after ingested by the animals
food + drinkFirm says it has created the "rarest" coffee in the world
Arts and Entertainment
Jamie T plays live in 2007 before going on hiatus from 2010
arts + entsSinger-songwriter will perform on the Festival Republic Stage
Life and Style
food + drinkThese simple recipes will have you refreshed within minutes
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Junior Quant Analyst - C++, Boost, Data Mining

£30000 - £50000 per annum: Harrington Starr: Junior Quant Analyst - C++, Boost...

Junior Quant Analyst (Machine Learning, SQL, VBA)

£30000 - £50000 per annum: Harrington Starr: Junior Quant Analyst (Machine Lea...

C#.NET Server Side Developer (C#, XML, WCF, Unit Testing,SQL)

£30000 - £40000 per annum + benefits+bonus+package: Harrington Starr: C#.NET ...

Junior Database developer (SQL, T-SQL, Excel, SSRS)

£20000 - £30000 per annum + benefits+bonus+package: Harrington Starr: Junior D...

Day In a Page

All this talk of an ‘apocalyptic’ threat is simply childish

Robert Fisk: All this talk of an ‘apocalyptic’ threat is simply childish

Chuck Hagel and Martin Dempsey were pure Hollywood. They only needed Tom Cruise
Mafia Dons: is the Camorra in control of the Granite City?

Mafia Dons: is the Camorra in control of the Granite City?

So claims an EU report which points to the Italian Mob’s alleged grip on everything from public works to property
Emmys look set to overhaul the Oscars as Hollywood’s prize draw

Emmys look set to overhaul the Oscars as Hollywood’s prize draw

Once the poor relation, the awards show now has the top stars and boasts the best drama
What happens to African migrants once they land in Italy during the summer?

What happens to migrants once they land in Italy?

Memphis Barker follows their trail through southern Europe
French connection: After 1,300 years, there’s a bridge to Mont Saint-Michel

French connection: After 1,300 years, there’s a bridge to Mont Saint-Michel

The ugly causeway is being dismantled, an elegant connection erected in its place. So everyone’s happy, right?
Frank Mugisha: Uganda's most outspoken gay rights activist on changing people's attitudes, coming out, and the threat of being attacked

Frank Mugisha: 'Coming out was a gradual process '

Uganda's most outspoken gay rights activist on changing people's attitudes, coming out, and the threat of being attacked
Radio 1 to hire 'YouTube-famous' vloggers to broadcast online

Radio 1’s new top ten

The ‘vloggers’ signed up to find twentysomething audience
David Abraham: Big ideas for the small screen

David Abraham: Big ideas for the small screen

A blistering attack on US influence on British television has lifted the savvy head of Channel 4 out of the shadows
Florence Knight's perfect picnic: Make the most of summer's last Bank Holiday weekend

Florence Knight's perfect picnic

Polpetto's head chef shares her favourite recipes from Iced Earl Grey tea to baked peaches, mascarpone & brown sugar meringues...
Horst P Horst: The fashion photography genius who inspired Madonna comes to the V&A

Horst P Horst comes to the V&A

The London's museum has delved into its archives to stage a far-reaching retrospective celebrating the photographer's six decades of creativity
Mark Hix recipes: Try our chef's summery soups for a real seasonal refresher

Mark Hix's summery soups

Soup isn’t just about comforting broths and steaming hot bowls...
Tim Sherwood column: 'It started as a three-horse race but turned into the Grand National'

Tim Sherwood column

I would have taken the Crystal Palace job if I’d been offered it soon after my interview... but the whole process dragged on so I had to pull out
Eden Hazard: Young, gifted... not yet perfect

Eden Hazard: Young, gifted... not yet perfect

Eden Hazard admits he is still below the level of Ronaldo and Messi but, after a breakthrough season, is ready to thrill Chelsea’s fans
Tim Howard: I’m an old dog. I don’t get too excited

Tim Howard: I’m an old dog. I don’t get too excited

The Everton and US goalkeeper was such a star at the World Cup that the President phoned to congratulate him... not that he knows what the fuss is all about
Match of the Day at 50: Show reminds us that even the most revered BBC institution may have a finite lifespan – thanks to the opposition

Tom Peck on Match of the Day at 50

The show reminds us that even the most revered BBC institution may have a finite lifespan – thanks to the opposition