AIG's bailout expanded

American International Group, an insurance firm that was recently given an $85 billion loan from the Treasury, just renegotiated the terms of its bailout.

AIG was facing insolvency. It had written a number of credit default swaps. Firm A might be worried for whatever reason that Firm B will default (e.g. A owns bonds from B); to hedge this risk, A might buy a credit default swap from AIG. As with any insurance contract, the insurer needs to post some collateral in case the insurer defaults. However, if the insurer's credit rating is lowered, the insurer needs to post additional collateral. AIG's credit rating was under threat of a severe downgrade, and it faced a situation where it would need to post more cash collateral than it had.

And so, AIG got a $85 billion bridge loan from the US Federal Government. The loan carried rather high interest. AIG would essentially need to sell off whatever assets it could to pay the loan off; it would be left a fraction of its former sprawling self.

However, the firm hasn't been able to sell assets. No one is able to buy (although some are apparently willing). The Treasury sharply reduced the interest rate on the loan, and purchased preferred stock in AIG (preferred stock is similar to bonds). However, the new package is worth $150 billion. The Treasury will of course maintain its warrants in the company, which give it a claim on 80% of the company's equity.

AIG's demise would have hurt a number of other large financial firms, which would in turn have deleterious consequences to Americans. US taxpayers shouldn't necessarily oppose increasing the loan to the firm ... but the stakes have got a lot higher. An article by the Motley Fool compares AIG to two previous bailouts where the government lost money - $1.1 billion in a 1984 bailout. The author says one of the risk of government bailouts is "becoming bogged down in a money quicksand pit" - there may be good reason to attempt to prevent AIG from self-destructing, but taxpayers do have good reason to be worried.