WASHINGTON - In the largest single financial intervention in the nation's history and a measure of the depths of America's financial crisis, the Federal Reserve will lend insurance giant American International Group Inc. $85 billion to finance the company's liquidation over the next two years, people familiar with the decision said last night.
The loan represents an abrupt turnaround for the Fed, which as late as Monday night indicated that the nation's big investment banks would provide emergency financing for AIG and as recently as last weekend appeared to be signaling an end to government rescues of private firms by allowing Lehman Bros. Holdings Inc. to go belly up and Merrill Lynch & Co. to be snapped up in a rushed purchase by Bank of America.
Fed Chairman Ben S. Bernanke acted after AIG, the world's largest insurer, told the government that without aid the company would file for bankruptcy last night, a move that Fed officials concluded would send devastating ripples through the global financial system and jeopardize economies around the world.
Bernanke and Treasury Secretary Henry M. Paulson Jr. went to Capitol Hill at 6:30 p.m. to brief top House and Senate leaders in the offices of Senate Majority Leader Harry Reid of Nevada. But people familiar with the discussions said the central bank chairman and the top Bush administration official had already made the decision on the loan by the time they arrived.
The two-year loan will be backed by all of AIG's assets, and is expected to be repaid by sales of the firm's assets. It will give the U.S. government an 80 percent stake in the company and the power to veto dividend payments to common and preferred shareholders.
In a statement issued at 9 p.m., the central bank said that the Fed board approved the loan after determining 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."
AIG has its corporate fingers in 130 states and nations across the United States and around the world. The New York-based holding company with its scores of subsidiaries is the second-largest insurer in the United States in direct written premiums and the largest in the world when measured by its about $1 trillion in assets.
Top lawmakers generally expressed support for the plan. But the bailout is likely to prove controversial, because it effectively puts taxpayer money at risk while protecting bad investments made by AIG and other institutions it does business with.
What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but AIG's role as an enormous provider of financial insurance, which effectively requires it to cover losses suffered by other institutions in the instance of defaults of securities that they have purchased. That means AIG is potentially on the hook for securities that were once considered safe.
If AIG 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 billions of dollars in debt securities, which in turn would have reduced their own capital and the value of their own debt.
"It would have been a chain reaction," said Uwe Reinhardt, a professor of economics at Princeton University. "The spillover effects could have been incredible."
Financial markets, which had plunged Monday over worries about AIG's possible collapse, reacted with relief to the news of the bailout. In anticipation of a deal, stocks rose about 1 percent in the U.S. yesterday and were up about 2 percent in early trading in Asian markets this morning.
Still, the move will likely spark an intense political debate during the presidential election campaign over who is to blame for the financial crisis that prompted the rescue.
The decision was a remarkable turnabout by the Bush administration and Paulson, who had flatly refused over the weekend to risk taxpayer money to prevent the collapse of Lehman Brothers or the distressed sale of Merrill Lynch to Bank of America. Earlier this year, the government bailed out another investment bank, Bear Stearns, by engineering a sale to JPMorgan Chase that left taxpayers on the hook for up to $29 billion of bad investments by Bear Stearns.
News of the federal action should spark a stock rally when the market opens today, said John Buckingham, chief executive at Al Frank Asset Management in Laguna Beach, Calif. He noted that rumors of an AIG rescue sparked a rally this afternoon even in the face of investor disappointment over the Fed's failure to cut interest rates.
"We had people bailing out of the market [yesterday] on speculation that things were going to get dramatically worse," said Buckingham, who owns AIG shares in his portfolio. "Now, if they don't, you'll see a lot of that negative action unwind."
Fed and Treasury officials initially had turned a cold shoulder to AIG when company executives pleaded Sunday night for the Fed to provide a $40 billion bridge loan to stave off a crippling downgrade of its credit ratings as a result of tens of billions of dollars of losses related to insurance investments that have turned sour.
But government officials reluctantly backed away from their tough-minded approach after a failed attempt to line up private financing with help from JPMorgan Chase and Goldman Sachs.
Another reason that AIG posed systemic risk is that it might have been forced to liquidate real estate and other assets at fire sale prices - a move that could drive property prices lowers and force countless other companies to mark down the value of their own holdings.
The complexity of AIG 's business, and the fact that it does business with thousands of companies, make its survival critical at a time when there is stress throughout the financial system worldwide.
"It's the interconnectedness and the fear of the unknown, meaning the impact of a failure," said Roger Altman, a former Treasury official in the Clinton administration. "But size is a factor; you can't ignore that. The prospect of world's largest insurer failing, together with the interconnectedness and the uncertainty about the collateral damage - that's why it's scaring people so much."
The Los Angeles Times and The New York Times contributed to this article.