Fed gives AIG $85 billion loan

Central bankers around the world tried to revive credit markets.

NEW YORK (AP) — The Federal Reserve resisted a cut in interest rates Tuesday and then forged a plan to take over American International Group Inc. and rescue the insurance giant from the brink of bankruptcy with an extraordinary $85 billion loan.

The moves, along with a slight rebound on Wall Street, offered some respite after the chaos that shook the financial system Monday when investment house Lehman Brothers declared bankruptcy and the Dow Jones industrials suffered its biggest point drop since the 2001 terrorist attacks.

Investors worried that a failure by AIG, the world’s largest insurer, would set off even more financial turmoil.

AIG is little known off Wall Street but does business with almost every financial institution in the world. It insures $88 billion worth of assets and plays an outsized role insuring mortgages and corporate loans, but even more threatening was its integral role in the murky world of hedge funds and credit derivatives.

People with knowledge of the situation, who asked not to be identified because of the sensitive nature of the negotiations, said bankers and federal officials had decided a government bailout of AIG was the best solution to save it from collapse.

The plan called for the government to seize up to 80 percent of the company and remove its management, similar to the way it took control of mortgage giants Fannie Mae and Freddie Mac.

All three major credit rating agencies had cut AIG’s ratings at least two notches late Monday night, and though the new ratings were still considered investment grade, they added pressure on AIG as it sought tens of billions of dollars to strengthen its balance sheet.

New York Gov. David Paterson said Monday he would support allowing AIG to use $20 billion of assets held by its subsidiaries to pay for its business — essentially giving it a bridge loan from itself.

A collapse of AIG would force Wall Street to untangle the complex credit derivatives markets and send the market scrambling to figure out who owes what to whom — or even who owns what.

“Regulators knew that if Lehman went down, the world wouldn’t end,” money manager Michael Lewitt wrote in an op-ed column Tuesday in The New York Times. “But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if AIG collapsed.”

The Fed stepped in hours after it decided, in its first unanimous vote this year, to keep the closely watched federal funds rate unchanged at 2 percent. At the same time, however, the Fed noted that strains on the market have “increased significantly” and said it was ready to act if needed.

Stocks slumped immediately after the Fed announcement. The Dow initially dropped about 100 points but rallied to finish the day up 141, and back over 11,000.

As AIG teetered, central bankers around the globe scrambled to revive credit markets. The Fed injected $70 billion into the American financial system. The European Central Bank pumped one-day financing of nearly $100 billion into the 15-nation zone. The Bank of Japan added $24 billion, and England’s central bank almost $36 billion.

Cash left world markets Monday like an outgoing tide. The interest rate banks charge each other for overnight loans soared as high as 6 percent — far above the Fed’s target rate of 2 percent and a sign banks didn’t trust each other enough to make even 12-hour loans.

Meanwhile, British bank Barclays PLC planned to announce by early today its intention to acquire all or part of Lehman Brothers Holdings Inc.’s investment banking and trading operations, a person close to the talks said. The person spoke on the condition of anonymity because a final agreement had yet to be reached. Lehman Brothers filed the largest bankruptcy in American history Monday.

Separately, Bank of America Corp., which in July bought battered Countrywide Financial Corp., began to work out how it would digest its $40 billion acquisition of Merrill Lynch after its shotgun wedding with the brokerage Sunday.

In the wings, Goldman Sachs Group Inc., which began the year as one of five large investment banks and is now one of two, reported its worst profit drop since going public in 1999. Goldman’s third-quarter profit dropped 71 percent to $810 million, while revenues plummeted 50 percent.

The only other investment bank left standing, Morgan Stanley, had better news. It reported solid quarterly profits — though down 7 percent from a year earlier — and surpassed Wall Street’s expectations.

Earlier this year, the federal government engineered the sale of Bear Stearns to JPMorgan Chase, and earlier this month the government assumed control of mortgage giants Fannie Mae and Freddie Mac.

On the campaign trail, Republican presidential nominee John McCain called for a commission to study the economic crisis. Democrat Barack Obama laughed the idea off as “the oldest Washington stunt in the book.”

“This isn’t 9/11,” Obama told a noisy crowd of more than 2,000 at the Colorado School of Mines, dismissing the idea of a need for study. “We know how we got into this mess. What we need now is leadership that gets us out. I’ll provide it. John McCain won’t.”

McCain, campaigning in Florida, promised reforms, too, to expose and end the “reckless conduct, corruption and unbridled greed” on Wall Street that he said had caused the financial crisis.

To say that it is an unusual week in U.S. finance would be a huge understatement. On Tuesday, the Web site Christianity Today even posted an e-mail from an evangelical leader asking Christians to pray for Wall Street.

“We may find it hard to pray for these bankers because they are insanely wealthy, true,” it read. “A few of them can be terribly arrogant; and some can have little heart for the less wealthy. Yet, Jesus prayed for the rotten because he loved the rotten. In this situation prayer could accompany a revival of the heart on Wall Street.”