- The Washington Times - Wednesday, September 17, 2008

The Federal Reserve of New York on Tuesday night issued an emergency $85 billion loan to American International Group, stepping in to stave off the giant insurer’s bankruptcy amid fears its failure would further undermine fragile credit and stock markets.

The Fed acted hours after Wall Street lenders balked at bailing out AIG, whose woes worsened as big credit downgrades overnight Monday made it harder to raise more than $80 billion in funds it needs to meet commitments.

“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 Federal Reserve said.

The deal gives the government a 79.9 percent stake in AIG, the right to remove senior management and to veto payment of dividends to shareholders as ways to protect taxpayers.

The White House praised the action to “limit damage to the broader economy.”

With other troubled institutions such as Washington Mutual hanging in the balance, regulators feared that the failure of AIG on top of Lehman Brothers’ bankruptcy on Monday could produce cascading defaults and a freeze in credit markets that could push other debt-plagued institutions over the edge.

Hopes of a Fed rescue for AIG — only a day after Treasury Secretary Henry M. Paulson Jr. declared no more federal bailouts — helped lift the stock market, with U.S. stock indexes bucking the trend of stock drubbings in overseas markets to post modest gains.

Asian stock markets rebounded Wednesday morning from a dramatic sell-off as the rescue plan of AIG restored confidence in the global financial system for now.

Tokyo’s benchmark Nikkei-225 index rose more than 2 percent in the Wednesday morning session. On Tuesday, the Nikkei plunged nearly 5 percent to a more than three-year low after the collapse of Lehman.

While the Fed was moving Tuesday toward the unprecedented step of aiding an insurance company in what would be its first financial rescue since Bear Stearns in March, central bank leaders in Washington decided against cutting interest rates, citing their belief that the financial crisis can be contained on Wall Street without serious damage to the economy.

Last night’s move is bound to raise questions about the use of taxpayer money to bail out private firms.

Earlier Tuesday, the top Republican on the Senate Banking, Housing and Urban Affairs Committee said the Bush administration doesn’t appear to have a set policy for deciding when to support private-sector bailouts.

After talking at length with Mr. Paulson, Sen. Richard C. Shelby of Alabama said the administration is sending a “mixed message.”

He questioned Mr. Paulson about how the Treasury Department could help another firm after deciding over the weekend not to offer a lifeline to newly bankrupt Lehman Brothers.

“I was not satisfied with his answers,” Mr. Shelby said. “I said, ‘Mr. Secretary … you’re picking and choosing. You have to have a set policy.’”

In addition to the loan, New York insurance regulators provided AIG with regulatory relief, enabling the insurer to borrow $20 billion in cash from subsidiaries.

“While we do not generally support government intervention in these situations, in this case we do support the Federal Reserve being part of a private-sector effort to stabilize AIG,” said New York Attorney General Andrew M. Cuomo.

“Given AIG’s interconnections, its failure would pose serious hardships to many companies and individuals. The Fed’s leadership and collaboration is therefore essential.”

As an alternative to lowering interest rates, the Fed attempted to calm stressed markets with a massive joint operation with the European Central Bank, infusing $140 billion of cash into the critical funding markets where banks obtain the cash they need to lend to businesses and individual consumers.

Fear about a rash of bankruptcies has caused those markets to freeze, with the interest rates paid by banks for overnight loans doubling in London and surging wildly in New York, while corporate borrowing costs soared.

“The problems are the clogged pipelines in the credit markets,” said Sung Won Sohn, economics professor at California State University. “Lower interest rates at this time would not solve any problems in the financial markets. The market is not short of liquidity; it is short of confidence.”

The Fed views its other actions, including the cash infusion and a move over the weekend to broaden the number of credit instruments it will accept as collateral at its loan discount window for banks and Wall Street firms, as “substitutes for rate cuts,” he said.

The Fed acknowledged Wall Street’s turmoil, saying “strains in financial markets have increased significantly and labor markets have weakened further.” Combined with “tight credit conditions and the ongoing housing contraction,” it said, the crisis is likely to slow growth in coming months.

But the Fed said the substantial cuts in interest rates it provided earlier this year should suffice to keep the economy growing at a moderate rate. It added that it still has “significant concern” that inflation will worsen, despite a rare energy-induced decline in the Consumer Price Index reported by the Labor Department earlier Tuesday.

Richard Yamarone, an economist with Argus Research Corp., said the Fed may have decided against cutting rates because it wants to reserve the option of taking action if more major bankruptcies rock the financial markets in coming days.

“It may be the case that the Fed is keeping its powder dry in the event AIG or some other major bank failure wallops the markets, which could be the looming fear that would force the Fed to slash rates,” he said. There could be “something much bigger than Lehman and Merrill Lynch looming in the wings.”

On Capitol Hill, a key congressional Democrat said the turmoil on Wall Street is prompting consideration of a broad federal market rescue that could include a new government entity to take over collapsed financial institutions and sell off their assets, as lawmakers did during the 1980s savings and loan crisis.

Rep. Barney Frank, Massachusetts Democrat and chairman of the House Financial Services Committee, said a body like the Resolution Trust Corp. - the largely taxpayer-financed company that seized and liquidated the savings and loans - might be needed in coming months to stabilize markets and prevent more implosions at major financial institutions.

His panel plans a hearing Sept. 23 to hear from economists and others “to begin the process of thinking about” the idea.

In a more immediate step designed to help regulators deal with the credit crisis, Democrats said they have agreed to give the Federal Reserve authority to pay interest on commercial bank reserves, a move that could give the central bank better control over interest rates. The measure, which Mr. Frank said would cost $300 million over the next two years, is likely to become part of the final spending package Congress passes this month before adjourning.

  • This article is based in part on wire service reports.

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