Issue of the week: Why the Fed saved AIG

In the end, it came down to a choice between standing on principle or risking a global financial meltdown, said Hugh Son and Erik Holm in Bloomberg.com. After refusing to rescue Wall Street giants Lehman Brothers and Merrill Lynch, the U.S. government this week took the extraordinary step of extending an $85 billion line of credit to AIG, a sprawling insurer that does business with nearly every major financial institution on the planet. In return for the loan, AIG effectively gave the Federal Reserve 80 percent of the company, decimating the stakes held by existing shareholders. Without the loan, AIG would have had little choice but to seek bankruptcy-court protection and could have saddled global financial institutions with losses of $180 billion or more. “Nobody really knew how bad it could have been,” said UBS analyst David Havens.

It would have been “catastrophic,” said Andrea Felsted and Kate Burgess in the Financial Times. AIG is woven so tightly into the financial system that its failure would be like “taking the foundation stone out of a skyscraper.” What’s ironic is that many of its businesses, including life insurance and retirement services, are profitable. But it ran into a buzz saw when it agreed to insure almost $441 billion in debt securities, including $58 billion in subprime mortgages, against default. To show it had the ability to honor its guarantees, AIG was required to back its insurance contracts with cash or high-grade bonds. But when AIG’s credit rating was downgraded this week, it had to pledge $14.5 billion in additional cash or securities to reassure investors. Failure to do so could have touched off the sort of crisis of confidence that doomed Bear Stearns and Lehman.

That’s the least of it, said Michael Lewitt in The New York Times. AIG’s failure “would be as close to an extinction-level event as the financial markets have seen since the Great Depression.” To pay off its creditors, AIG would have to sell hundreds of billions of dollars in stocks, bonds, and other assets. That would accelerate the slide in the financial markets and almost inevitably set off a daisy chain of defaults and failures around the world. In short, Wall Street wasn’t “remotely prepared for the inestimable damage the financial system would suffer if AIG collapsed.”

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Which is why the Fed’s loan came “not a moment too soon,” said David Reilly in The Wall Street Journal. But AIG is still in dire need of long-term capital, and it’s not at all clear where it will come from. Its stock price has fallen more than 90 percent since the first of the year, to less than $4, making it hard to sell additional shares. And a long-term private loan, even if AIG could arrange one, would come at a brutally high interest rate. So AIG may have little choice but to sell some of its most valuable subsidiaries, including its aircraft-leasing unit. That would be painful for AIG shareholders, “but it is better than the alternative. Just ask investors in Lehman Brothers.”