The Federal Reserve bails out AIG

At 9:00 PM EDT, the Federal Reserve posted a statement on its website that it has decided to offer AIG an $85 billion line of credit at a penalty rate in return for all of AIG as collateral. In addition, the Federal Reserve will receive an equity interest of 79.9% of the company. Note: the New York state offer to allow AIG to borrow $20 billion from its own subsidiary is now moot. AIG may well be liquidated in an orderly fashion as the loan is paid off over 24 months. It is still not known what will come of the company.

The line of credit, which is at a steep rate of LIBOR plus 850 basis points, is in accordance with Walter Bagehot‘s theory of central bankers as a lender of last resort: lend freely at a penalty rate.

This is exactly what the Federal Reserve should do. Ben Bernanke, in not raising rates and in providing liquidity to AIG at a penalty rate has done exactly what a Central Bank should do. I am impressed.

UPDATE: 1000PM: Aaron Krowne of bankimplode.com reminded me that the Federal Reserve is supposed to only lend to depositary institutions in this manner. Legally, the last-ditch actions by the Fed may not actually be legal.

NY State Governor David Paterson held a short press conference at 9:40. In the press conference, he said it is not known whether AIG will continue in its present form, be forced to sell off many assets, or liquidate.

Below is the statement. I will update this post as information becomes available.

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under Section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

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 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.

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.
–Federal Reserve

UPDATE 1040PM: Real Time Economics says the following about the Fed statement:

In lending up to $85 billion at a hefty interest rate ?- LIBOR plus 8.5 percentage points ?- to insurer AIG, the Federal Reserve once again relied on its rarely used legal authority under Section 13(3) of the Federal Reserve Act to lend to ?any individual, partnership or corporation? in ?unusual and exigent circumstance? provided the borrower ?is unable to secure adequate credit accommodations from other banking institutions.?
–Real-Time Economics

Note: this action by the Federal Reserve is going to increase the political will to reform the regulatory system for OTC derivatives, where AIG was a major player. The events surrounding AIG were very ugly, unscripted and potentially catastrophic. The United States will need a better regulatory framework going forward.