The Federal Reserve Board threw a life preserver to keep American International Group Inc. from drowning in subprime-related obligations last week, as the U.S. government took a 79.9 percent stake in the troubled firm in exchange for up to $85 billion in emergency financing. The 11th-hour deal meant AIG did not have to seek bankruptcy court protection, as had been cited as the worst-case scenario by a Fed official.

Meanwhile, Edward Liddy, the former chief executive officer for Allstate Corp., was tapped to run AIG's day-to-day operations as its new CEO.

Mr. Liddy was CEO of Northbrook, Ill.-based Allstate from 1999 until 2005. He replaces Robert Willumstad, still AIG's chairman, who took on the added CEO role in June when Martin Sullivan--who had replaced Maurice Greenberg--stepped down.

In the wake of the Fed's move, Standard & Poor's and Fitch both revised their ratings for AIG, but warned they would be keeping a close eye on how the situation develops.

As for the loan package, the Fed said it had authority under Section 13(3) of the Federal Reserve Act to approve the deal with AIG and was proceeding with the full support of the Treasury Department.

"The [Federal Reserve] 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 said in a statement.

"The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due," the Fed explained. "This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy."

AIG's board issued a statement welcoming the move by the Federal Reserve to set up the $85 billion revolving credit facility, noting that it "approved this transaction based on its determination that this is the best alternative for all of AIG's constituencies--including policyholders, customers, creditors, counterparties, employees and shareholders."

The board said that AIG is "a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues. 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."

AIG investors had expressed confusion about whether the Fed really would be taking ownership of 79.9 percent of AIG, or simply treating that percentage of AIG as collateral--only getting the 79.9 percent stake if AIG misses payments. But the AIG board said in its statement that "American taxpayers will receive a substantial majority ownership interest in AIG."

The Fed's agreement with AIG increases the number of AIG shares by 500 percent, to 13.4 billion. Put another way, the deal dilutes the value of a shareholder's holding of AIG common stock by 80 percent.

In any case, the proceeds of subsequent asset sales should be enough for AIG to repay the loan in full, the company's board said. "Policyholders of AIG companies around the world can rest assured that AIG's commitments will continue to be honored," the board added.

In another related development, New York Insurance Superintendent Eric Dinallo--a critical player throughout AIG's salvage operation--will head up a national task force of state regulators overseeing the sale of any of AIG's insurance assets.

In an effort to provide enough collateral to keep AIG afloat, New York Gov. David Paterson on Sept. 15 announced that the state would allow AIG to move up to $20 billion in capital from its insurance subsidiaries to the parent firm to help shore up its finances.

While such a transfer might no longer be necessary with the Federal Reserve loan deal in place, Gov. Paterson emphasized that the offer had stabilized AIG's precarious financial position while negotiations for a more permanent solution continued.

The New York Fed credit facility set up under the deal has "terms and conditions designed to protect the interests of the U.S. government and taxpayers," the Fed noted. The facility has a life of 24 months and a maximum liability of $85 billion.

"The loan is collateralized by all the assets of AIG and of its primary nonregulated subsidiaries," the Fed explained. "These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm's assets."

In addition to getting a 79.9 percent equity interest in AIG, the government will have the right to veto the payment of dividends to common and preferred shareholders, the Fed noted.

The Fed also will get veto power over "important management decisions," such as the sale of subsidiaries, according to a Fed official, who added that for the moment, the AIG board will remain the same.

Insurance subsidiaries and affiliates will remain subject to state regulation.

The Fed decided to acquire 79.9 percent of AIG rather than 80 percent or more, because 80 percent control would have triggered accounting mandates that would have complicated running the business, the Fed official explained.

Another source who requested anonymity said state insurance regulators would have to approve any change in control over AIG insurance subsidiaries but would not have to approve the Fed's financing arrangement.

AIG has been suffering for months from the effects of economic turmoil on mortgage loans and other loans. The upheaval has caused billions of dollars in losses at the company's credit default swaps operation, which insures bondholders against defaults.

Last week, when Lehman Brothers began sliding toward bankruptcy, AIG warned the Fed that such a high-profile failure could cause the rating agencies to cut its own ratings, triggering massive collateral calls that AIG had too little ready cash to meet.

AIG managers warned the Fed that the absolute last day the company would have to act would be Sept. 16, the Fed official said.

Credit rating agencies behaved as AIG had predicted. They cut AIG's ratings on Sept. 15, exposing AIG to the threat of calls for more than $14 billion in collateral as well as to the threat of contract cancellations.

The price of AIG shares fell 46 percent last week, and closed Friday at $12.14 per share. On Sept. 16, the price of AIG shares opened at $1.85 and closed at $3.75.

On Tuesday afternoon, Bloomberg News reported that the Fed was thinking about putting AIG in a conservatorship, as it has done with the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp. However, although the government will effectively control AIG, "this is not a conservatorship," the Fed official explained.

The senior Fed official said the government decided to provide access to cash for AIG but not for Lehman Brothers, which filed for bankruptcy protection on Sept. 15, because AIG constituted a "systemic risk" to the financial system.

The markets and regulators seem to be more prepared for the failure of an investment bank than for the insolvency of a complex insurance company, the official explained.

Special Reports /

Fed Rescues AIG With Bridge Loan, Buying Two Years To Sell Off Assets

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