The Federal Reserve Board on Sept. 16 took the unprecedented step of taking control of 79.9% of American International Group’s stock in return for a loan of up to $85 billion designed to allow the company to “fund its operations in an orderly fashion.”

A Fed official said that daily operations “will be business as usual for AIG”

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.

“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 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.”

AIG is a huge international company with more than $1 trillion in assets, including a number of property casualty and life insurance subsidiaries, as well as aircraft leasing and auto lending units. It also has a now-dormant mortgage lending unit.

The documents were signed by AIG’s board and Fed officials just after 9 p.m. on Sept. 16, several hours after Fed and Treasury Department senior officials briefed key members of Congress on the decision.

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of 3-month Libor plus 850 basis points, the Fed said. The rate equates to 11.3%.

Insurance subsidiaries and affiliates will remain subject to state regulation, but the “government” will appoint new management, the official said. Edward Liddy, former Allstate Corp. CEO was reported to be named to replace Robert Willumstad, AIG’s current CEO, according to a CNBC interview with Eric Dinallo, New York Superintendent (see related story below.) The board will remain the same at the moment, a senior Fed aide said.

The loan will be “fully” collateralized not by the assets of a particular subsidiary or affiliate, but the entire entity, the Fed official said.

But, the Fed official said he was “not prepared to answer” why the private sector declined during several days of talks to provide the company with liquidity.

A New York Insurance Department official said the effective takeover did not have to be approved by state regulators, but that appointment of new management will have to be approved by state regulators.

The loan covenant will give the agency veto power over “important management decisions,” such as sale of subsidiaries and payment of dividends.

A senior Fed official said the decision was made to provide liquidity to AIG but not to Lehman Bros., which filed for bankruptcy protection early on Sept. 15 because AIG constituted a “systemic risk” to the system.

The difference was that the markets and regulators were more prepared for a 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.

Later on the evening of Sept. 16, Treasury Secretary Henry Paulson added that, “These are challenging times for our financial markets.”

He said that the Treasury Department is “working closely with the Federal Reserve, the SEC and other regulators to enhance the stability and orderliness of our financial markets and minimize the disruption to our 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 concluded.

The decision followed a week of uncertainty that began on Sept. 11 when the value of Lehman Bros. stock began eroding, and the stocks of other financial institutions which owned mortgage-backed securities backed by sub-prime loans or which, like AIG, guaranteed the value of those securities through credit default swaps, began declining precipitously.

At that time, according to sources, AIG officials said that a Lehman failure would likely trigger a decline in AIG stock, prompting rating agencies to downgrade its credit standing. That would trigger margin calls by counterparties to CDS issued by AIG, company officials told the Fed. The concern, AIG officials told the Fed, is that AIG wouldn’t have access to the cash to produce that collateral.

According to a Fed official, they were told by AIG management that the absolute last day the company had to act would be on Sept. 16.

Given the failure of talks to create a private sector solution, the Fed aide said AIG asked for government help.

By the end of trading on Sept. 16, the shares of AIG had dropped from the $24 range on Sept. 11 to $3.75 a share, down $1.01, or 21%. But, it had traded as low as $1.40 in intraday trading.

More than 1.232 billion shares traded on the New York Stock Exchange as the stock fluctuated wildly as investors began to speculate around mid-day that the Fed would merely provide backup for a private sector loan.

But, as word seeped out that AIG might be subject even to a “conservatorship,” the stock dropped to $2.60, down an additional $1.15.

A Fed official said, “this is not a conservatorship” similar to the takeovers of Fannie Mae and Freddie Mac.

Pressure was also put on the government by New York Gov. David Paterson and New York City mayor Michael Bloomberg, officials said.