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September 17th, 2008

Fed Reconsiders, $85 Billion Bailout for AIG

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After refusing to extend a $40 billion loan to struggling insurer AIG on Sunday, the Fed reevaluated AIG’s systemic risk and decided to pledge an $85 billion loan yesterday — the fourth such rescue of a major financial player in six months. Once again, this loan will be riding on taxpayers’ shoulders.  In exchange for the two-year loan, the government will receive 79.9% ownership of AIG through common stocks.

It wasn’t the fact that another major financial player could go bankrupt that caused the Fed to reassess their decision; AIG’s extensive global influence could cause a domino effect that would be felt by institutions worldwide. AIG is an insurer of securities held by companies around the globe. If AIG were to fail, all of those companies would be left with uninsured securities that would in effect drain out their capital:

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s role as an enormous provider of esoteric financial insurance contracts to investors who bought complex debt securities. They effectively required A.I.G. to cover losses suffered by the buyers in the event the securities defaulted. It meant A.I.G. was potentially on the hook for billions of dollars’ worth of risky securities that were once considered safe.

If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt. Small investors, including anyone who owned money market funds with A.I.G. securities, could have been hurt, too. And some insurance policy holders were worried, even though they have some protections.

Critics of the bailout point to the lack of regulation that allowed AIG’s insurance companies to branch out beyond standard insurance contracts into riskier investments in real estate and mortgage backed securities:

But before the company could really rebuild itself, it became embroiled in the mortgage crisis. Some of its insurance companies ended up with mortgage-backed securities on their books, but the real trouble involved the insurance that its financial products unit offered investors for complex debt securities.

Why was Lehman Brothers allowed to fail, but not AIG? According to the Fed, markets had more time to prepare for Lehman’s down slide, unlike AIG’s which occurred with much less notice. What does AIG’s $85 billion loan mean to consumers? Your taxpayer money is at risk if AIG defaults. Cross your fingers.

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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