The Federal Reserve Board says the U.S. government will be getting a 79.9% stake in American International Group Inc. in exchange for the Federal Reserve Bank of New York providing up to $85 billion in financing.

The Fed says it has authority under Section 13(3) of the Federal Reserve Act to approve the deal and is proceeding with the full support of the Treasury Department.

The government is intervening in part because of a concern that a failure of the AIG operations that act as counterparties in derivatives transactions and other complex transactions could trigger failures throughout the financial services industry.

AIG noted in May, in a prospectus filed with the U.S. Securities and Exchange Commission, that the AIG Financial Products Corp.’s super senior credit default swap portfolio has a total of about $469 billion in “notional exposure” to defaults.

“The [Federal Reserve] 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 says in a statement.

“The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due,” the Fed says. “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 Fed’s Authority

Section 13(3) of the Federal Reserve Act states the following:

3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank:

Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.

AIG’s Views

The AIG board has issued a statement welcoming the the move by the Fed and the New York Fed to set up the $85 billion revolving credit facility.

The board “has approved this transaction based on its determination that this is the best alternative for all of AIG’s constituencies, including policyholders, customers, creditors, counterparties, employees and shareholders,” the board says.

“AIG is a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues,” the board says. “We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis.”

AIG investors have been expressing confusion about whether the Fed really will be taking ownership of 79.9% of AIG or simply treating that percentage of AIG as collateral and getting the 79.9% stake if AIG misses payments.

The AIG board says in its statement that, “American taxpayers will receive a substantial majority ownership interest in AIG.”

The proceeds of the sales should be enough for AIG to repay the loan in full, the board says.

“Policyholders of AIG companies around the world can rest assured that AIG’s commitments will continue to be honored,” the board says.

In the statement, the AIG board thanks New York Gov. David Paterson, D; New York State Insurance Superintendent Eric Dinallo; Pennsylvania Insurance Commissioner Joel Ario; other state insurance commissioners; officials at the Fed and Treasury Department; and officials at the Office of Thrift Supervision.

The Deal

The New York Fed credit facility “has terms and conditions designed to protect the interests of the U.S. government and taxpayers,” the Fed says.

The New York Fed’s AIG credit facility has:

- A 24-month term.

- An $85 billion maximum.

- A variable interest rate that will equal the London Interbank Offered Rate plus 8.5 percentage points.

The initial interest rate would be over 11%, but AIG apparently would have to pay interest only on the amounts that it draws from the facility.

“The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries,” the Fed says. “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.”

In addition to getting a 79.9% equity interest in AIG, the government will have the right to veto the payment of dividends to common and preferred shareholders, the Fed says.

The Fed also will get veto power over “important management decisions,” such as sales of subsidiaries, a Fed official said.

Insurance subsidiaries and affiliates will remain subject to state regulation.

Management

The government has not yet decided whether the Fed or the Treasury Department will be in charge of appointing new management at the holding company level, the Fed official said.

For the moment, the official said, the AIG board will remain the same, but New York Insurance Superintendent Eric Dinallo has confirmed that Edward Liddy, the former chief executive officer of Allstate Corp., Northbrook, Il.., is being recruited to run AIG’s day-to-day operations.

Liddy, 62, was CEO of Allstate from 1999 until 2005.

He would take the AIG CEO title from AIG Chairman Robert Willumstad. Willumstad, who is still AIG’s chairman, added the CEO title in June, when Martin Sullivan stepped down.

Newsday is reporting that Dinallo, who was heavily involved with the efforts to keep AIG out of bankruptcy court, will lead a national task force of state regulators overseeing the sale of any of AIG’s insurance assets.

The Fed decided to acquire 79.9% of AIG rather than 80% or more, because 80% control would have triggered accounting mandates that would have complicated running the business, the Fed official said.

Another source who requested anonymity says state insurance regulators would have to approve any change in control over AIG insurance subsidiaries but would not have to approve the Fed financing arrangement.

Despite the change in control, when AIG opens for business Wednesday, “it will be business as usual for AIG,” the Fed official said.

The Last Day To Act

AIG, one of the largest financial services companies in the world, has been suffering for months from the effects of economic turmoil on mortgage loans and other loans.

The upheaval has caused billions of dollars in losses at the company’s credit default swaps operation, which insures bond holders against defaults.

Last week, when Lehman Brothers Inc., New York, began sliding toward bankruptcy court, AIG warned the Fed that a Lehman Brothers failure could cause the rating agencies to cut its own ratings, triggering massive collateral calls that AIG had too little ready cash to meet.

AIG managers warned the Fed that the absolute last day the company would have to act would be Tuesday, the Fed official said.

Credit rating agencies behaved as AIG had predicted. They cut AIG’s ratings, exposing AIG to the threat of calls for more than $14 billion in collateral as well as to the threat of contract cancellations.

The price of AIG shares fell 46% last week and closed Friday at $12.14 per share.

Today, the price of AIG shares opened at $1.85 and closed at $3.75. Shares are now selling for $2.60 in after hours trading.

More than 1.2 billion shares traded on the New York Stock Exchange today.

In Singapore, news organizations carried reports of customers lining up to withdraw funds from a unit of AIG.

The Monetary Authority of Singapore says it is watching the local AIG subsidiary’s investments carefully but notes that the assets linked to insurance products sold in Singapore are segregated from the general assets of AIG.

This afternoon, Bloomberg reported that the Fed was thinking about putting AIG in a conservatorship, as it has done with the Federal National Mortgage Association, Washington, and the Federal Home Loan Mortgage Corp., Washington.

The New York Times later learned about a Fed move to trade temporary financing for a 79.9% stake in AIG.

Senior officials from the Fed and Treasury Department briefed key members of Congress on the arrangement.

AIG executives and government officials signed documents concerning the deal just after 9 p.m.

Although the government will control AIG, “this is not a conservatorship,” the Fed official said.

Reasons And Reactions

The senior Fed official said the government decided to provide access to cash for AIG but not for Lehman Brothers, which filed for bankruptcy protection Monday, because AIG constituted a “systemic risk” to the financial system.

The markets and regulators seem to be more prepared for the failure of an investment bank than for the insolvency of a complex insurance company, the official said.

“AIG is a complicated firm, which offers for sale substantial products, such as retail financial products, insurance, guaranteed investment contracts and annuities outside regulated insurance entities,” the official said.

Treasury Secretary Henry Paulson put out a statement noting his interest in working with the Fed, the U.S. Securities and Exchange Commission and other regulators to enhance the stability and orderliness of the financial markets and minimize the disruption to the U.S. economy.

“I support the steps taken by the Federal Reserve tonight to assist AIG in continuing to meet its obligations, mitigate broader disruptions and at the same time protect the taxpayers,” Paulson says in the statement.

Ken Crerar, president of the Council of Insurance Agents & Brokers, Washington, also welcomed the Fed’s move.

“We applaud efforts to help stabilize financial markets, and particularly AIG’s holding company, in order to ensure that going forward, the company’s promises to our members’ clients are kept and protected,” Crerar said.

“AIG has been an important and substantial player in the insurance market, and whatever happens, the first concern of our members is their clients,” Crerar said.

Democratic presidential candidate Sen. Barack Obama, D-Ill., and Republican nominee Sen. John McCain, R-Ariz., said over the weekend that they oppose federal efforts to rescue struggling financial services companies.

Sens. Richard Shelby, R-Ala., and Christopher Dodd, D-Conn., also have criticized the idea of the government helping AIG and other struggling financial services companies.