The US Federal Reserve didn’t cut interest rates this morning. It instead bailed out American International Insurance Group, once a major global insurer, with a two year loan of $US85 billion ($A106 billion) in the cruellest of ironies.

Only a few months ago AIG was the biggest US insurer by assets and a major global force. It had a market value earlier in the year of close to $US95 billion. This morning its shares traded at $US3.50, compared to the peak over the past year of more than $US70 a share. Its value at the close of trading was just over $US10 billion, but for all intents and purposes, it is now worthless.

Now the Fed is offering a huge insurer a one-way form of insurance (it will be terminal for AIG) to underwrite the global financial system. It is larger than anything so far attempted in the credit crunch and far more complex.

It’s a highly expensive deal for AIG, this sort of help doesn’t come cheap. The Fed will take a margin of 8.50% over the relevant London Interbank Offered Rate (LIBOR), according to its statement. LIBOR jumped to over 6% Tuesday night, so it’s going to be an expensive loan. In the after hours market AIG shares finished at $US2.60, another 30% loss as the Fed and its advisers and the company completed the huge, unprecedented bailout.

The Fed said under the two-year facility the US government will receive a 79.9% equity interest in AIG and has the right to veto payment of dividends to common preferred shareholders in the deal, which had the full support of the Treasury Department.

”The 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 the statement.

“The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. 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.”

In Australia meanwhile, the Reserve Bank flooded the financial system with over $4 billion in cash this morning as it sought to keep cash rates steady while the fate of American International Group (AIG) was being sorted out in New York.

After adding $A2.1 billion on Monday and $A1.895 billion Tuesday to meet a system deficit of $A1.39 million over the two days, the RBA added $A4.285 billion today to meet a system deficit of $2.18 billion. That was after the Exchange Settlement Account was left flush Tuesday night with over $4 billion in cash and nervous Australian banks wanted quick cash overnight in case AIG or some other big problem got worse.

The size of the cash injection this morning ($A2 billion above what was needed, after two days of extra funding of $1.3 billion a day), means the level of liquidity support by the central bank is now back to levels seen when Bear Stearns was rescued in March, and earlier in the latter months of 2007.

It came after central banks around the world injected well over $US200 billion into financial systems to keep liquidity levels high: the Fed added another $US50 billion Tuesday on top of the $US70 billion on Monday.

Nearly $US100 billion was injected in Europe and over $US35 billion in the UK: in Russia, close to $US20 billion was injected into the banking and stock markets after shares plunged, trading was suspended on the Moscow market for an hour and liquidity drained away.

A market report in the FT during the night claimed that some European banks were not accepting sovereign bonds from some European countries, including Italy, and wanted German Government securities. Even UK gilts were reported to have been rejected. That’s close to madness a a sign of how stretched confidence levels are around the world.

The reason for all this pumping was the doubt over the fate of AIG, which had somehow wormed its way to the centre of the global financial system and proved the adage that not only was it “too big to fail” but it was just too complex.

This is a company whose management over the past five years (three separate management groups, with the last lot more aware than the previous ones) that it had somehow sold billions and billions of dollars with of securities called credit default swaps and other forms of financial insurance (using AIG’s Prime Triple A balance sheet), without fully understanding what they were offering.

But far from moral hazard being involved in this arrangement, the Fed’s move doesn’t bail anyone out except the policyholders and other customers of AIG’s normal, everyday businesses (it’s has a huge airline leasing business and large insurance and reinsurance businesses in the US and elsewhere). There are over 1 million policyholders in Australia by some estimates.

The company’s local arm said today that its capital hadn’t been tapped and it remained in compliance with regulations from APRA, the main regulator.

The Fed moved to give the financial system time to work out the winners and losers from all those credit and other derivatives that AIG had written: that’s why there’s no moral hazard because there are huge claims to come.

Some of those will be triggered by the rescue of Fannie Mae and Freddie Mac, some by the failure of Lehman Bros, some by AIG’s own problems.

Peter Fray

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