Why the Fed pulled the trigger on AIG
What did the government get for its $85 billion? Time to try to unwind a company with $1 trillion in assets.
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NEW YORK (CNNMoney.com) -- The federal government's rescue of American International Group gave the insurance titan something even more important than access to $85 billion ... it gave AIG time.
Time is what the beleaguered insurer needs to unwind its sprawling operations - it has $1.1 trillion in assets and 74 million clients - in an orderly manner. Had the company been forced into bankruptcy, it would have to unload its subsidiaries quickly and at a deep discount.
"It gives time for AIG to sell assets without having to put out the fire sale sign," said Stewart Johnson, portfolio manager with Philo Smith & Co. a Stamford, Conn.-based investment bank specializing in insurance.
As in the case of any distressed company, sellers can't demand top dollar for their assets when they are in trouble. Just look at Lehman Brothers, which declared bankruptcy on Monday after the federal government refused to bail it out. The investment bank is now forced to sell its holdings at a deep discount. It pawned its North American operations to Barclays Tuesday for a paltry $1.7 billion.
But in AIG's case, the situation is even more serious. The company is much larger and complex than Lehman Brothers and its assets hitting the market all at once would likely cause worldwide chaos and send values plummeting. Experts question whether there are even enough qualified buyers out there to digest the company and its subsidiaries.
AIG came under attack last week as investors grew increasingly concerned about the company's capital levels. Over the weekend, it turned to the Federal Reserve for a loan, but officials had their hands full with Lehman Brothers' unraveling. Reluctant to help AIG, officials pushed investment banks to provide the funding, even as AIG's stock price fell 69% in two days.
After it became clear that the private sector would not come to AIG's aid, the Federal Reserve Tuesday night stepped in and gave the insurer access to as much as $85 billion. The offer is good for two years, but comes at a steep interest rate of nearly 11.4%.
In return, the government took a 79.9% stake in the insurer and expects AIG to sell off assets to repay the loan.
"[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. "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 troubles lie in its exposure to complex credit-default swaps - an insurance-like product that protects buyers from bond defaults. But while the parent company is suffering, many of its subsidiaries are not only profitable, they are desirable, experts said.
The company has more than enough collateral to back the loan, senior Fed staffers said Tuesday night. Experts interviewed agree that AIG's units are worth more than $85 billion.
The first businesses the company is likely to unload are its financial services unit, said Donald Light, senior analyst at Celent, a Boston-based financial research and consulting firm. However, since it is at the root of AIG's problems and lost $14.8 billion in the first half of 2008, AIG might not get much for it.
Its non-insurance subsidiaries, such as its aircraft leasing business that reported income of $555 million for the first six months of the year, will likely fetch more. Already, the unit's chief is looking to buy the company from AIG, the Wall Street Journal reported. Its fleet of 1,000-plus aircraft alone is valued at $55 billion.
What happens to the company's core insurance and retirement services subsidiaries is the big question. They are undoubtedly among AIG's most attractive units, but they are also the heart of the business. Its general insurance business - which includes property and casualty - brought in $2.2 billion in profits this year.
Its life insurance unit is likely the last thing the company wants to sell since it is the bedrock of AIG's business, experts said. Though the subsidiary has been hit this year by fallout from the credit crisis, forcing it to take a $9.6 billion charge in the first six months of the year, it is generally stable.
"They will try to keep all or nearly all of the insurance business in place," Light said.
The Fed likely took an equity stake in the company, rather than just giving AIG a loan, because it felt the company has a lot of value and might make money for taxpayers, said Anthony Sanders, professor of financial institutions at New York University. The government made a similar investment in Continental Illinois bank, which failed in 1984, and turned it around at a profit.
"The payoff on equity is unlimited on the upside," Sanders said. "With debt, you just get interest." 
