WASHINGTON — For the second time this month, the U.S. government put taxpayer money on the hook to rescue a private financial company, saying the failure of the huge insurer American International Group Inc. would further disrupt markets and threaten the already fragile economy.
The Federal Reserve said Tuesday it would provide up to $85 billion in an emergency, two-year loan to rescue AIG, which teetered on the edge of failure because of stresses caused by the collapse of the subprime mortgage market and the credit crunch that ensued. In return, the government will get a 79.9 percent stake in AIG and the right to remove senior management.
The move was similar to government's seizure on Sept. 7 of mortgage giants Fannie Mae and Freddie Mac, where the Treasury Department said it was prepared to put up as much as $100 billion over time in each of the companies if needed to keep them from going broke.
Both moves were bound to raise questions about the use of taxpayer money to bail out private firms.
The Fed said it determined that a disorderly failure of AIG could hurt the already delicate financial markets and the economy. Although little known off Wall Street, AIG does business with almost every financial institution in the world and insures $88 billion worth of assets including mortgages and corporate loans.
Its failure could also "lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," the Fed said in a statement.
The decision to help AIG reversed the government's stance over the weekend, when it refused to use taxpayer money to bail out Lehman Brothers Holdings Inc. Lehman, which filed for bankruptcy protection Monday, collapsed under the weight of mounting losses related to its real estate holdings.
The White House said it backed the Fed's decision Tuesday.
"These steps are taken in the interest of promoting stability in financial markets and limiting damage to the broader economy," White House spokesman Tony Fratto said.
After meeting with Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke in a late-night briefing on Capitol Hill, Congressional leaders said they understood the need for the bailout.
"The administration is approaching an unprecedented step, but unfortunately we are living in unprecedented times." said Sen. Charles Schumer, D-N.Y. "Hearing of these plans, you have to stop to catch your breath. But upon reflection, the alternatives are much worse."
New York officials said the deal helps stave off a fiscal crisis for the state.
"Policy holders will be protected, jobs will be saved," New York Gov. David Paterson said Tuesday night.
The Fed's move was part of a concerted push to help calm jittery markets and investors around the world.
On Tuesday, the Fed decided to keep its key interest rate steady at 2 percent, but acknowledged stresses in financial markets have grown and hinted it stood ready to lower rates if needed.
The central bank also pumped $70 billion into the nation's financial system to help ease credit stresses. In emergency sessions over the weekend, the Fed expanded its loan programs to Wall Street firms, part of an ongoing effort to get credit flowing more freely.
The stock market, which Monday had its worst session since the Sept. 11 attacks, recovered Tuesday after the Fed's decision on interest rates. The Dow Jones industrials rose 141 points after losing 500 points on Monday.
AIG's shares swung violently, though, as rumors of potential deals involving the government or private parties emerged and were dashed. By late Tuesday, its shares had closed down 20 percent _ and another 45 percent after hours.
The problems at AIG stemmed from its insurance of mortgage-backed securities and other risky debt against default. If AIG couldn't make good on its promise to pay back soured debt, investors feared the consequences would pose a greater threat to the U.S. financial system than this week's collapse of the investment bank Lehman Brothers.
The worries were heightened Monday after Moody's Investor Service and Standard and Poor's lowered AIG's credit ratings, forcing AIG to seek more money for collateral against its insurance contracts. Without that money, AIG would have defaulted on its obligations and the buyers of its insurance _ such as banks and other financial companies _ would have found themselves without protection against losses on the debt they hold.
"It might not just bring down other financial institutions in the U.S. It could bring down overseas financial institutions," said Timothy Canova, a professor of international economic law at Chapman University School of Law. "If Lehman Brother's failure could help trigger AIG's going down, who knows who AIG's failure could trigger next."
New York-based AIG operates an insurance and financial services businesses ranging from property, casualty, auto and life insurance to annuity and investment services. Those traditional insurance operations are considered healthy and the National Association of Insurance Commissioners said "they are solvent and have the capability to pay claims."