Stocks Plunge Despite Fed’s $85B Bailout of AIG

Manic and increasingly desperate dealmaking gripped Wall Street amid more signs of distress in the global financial industry.

Morgan Stanley was discussing a merger with regional banking powerhouse Wachovia while Washington Mutual , the country’s largest savings bank, put itself up for sale, the New York Times reported.

The flurry of takeover talks followed the surprise rescue of AIG by the U.S. Federal Reserve that did little to calm investors’ nerves.

The U.S. stock market plunged 4.7 percent to a three-year low, the dollar slumped and safe-haven U.S. Treasury bonds soared.

Concerns over AIG’s stability, and the potential far-reaching impact of its collapse, intensified this week after the bankruptcy of financial behemoth Lehman Brothers on Monday and the sale of Wall Street stalwart Merrill Lynch to Bank of America.

The reasons for AIG’s tumble echoed those of other companies: heavy investment in the subprime mortgage industry, soured real estate investments and the U.S. credit crunch.

The government’s decision to rescue AIG was similar to its 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 to keep the companies from failing.

The Fed’s decision marks another dramatic change of course in how it decides to parcel out government bailouts — earlier this week officials refused to rescue the struggling Lehman, the country’s fourth-largest
investment bank, saying taxpayer funds could not be used in all cases to repel the Wall Street crisis.

Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke held a late-night briefing Tuesday on Capitol Hill to explain to congressional leaders the reasons for the AIG bailout, according to media

“Thank God,” Daniel Fuss, a bond manager with Loomis, Sayles & Co in Boston told Reuters of the Fed’s intervention. “AIG is interwoven with so many people and touches many companies around
the world. This is a huge relief to many parts of the financial markets.”

Under the AIG deal, the Federal Reserve will provide a two-year $85 billion emergency loan to AIG. In return, the government will get a 79.9 percent stake in AIG and the right to remove senior management, the
Associated Press reported.

In a statement the Fed said it has determined that the failure of AIG could hurt the already fragile financial markets and the economy.

It also could “lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance,” the Fed said in a statement, according to the AP.

“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 said.

AIG’s chief executive, Robert Willumstad, is expected to be replaced by Edward Liddy, the former head of insurer Allstate Corp., according to a report in The Wall Street Journal. Willumstad has been the head of AIG
since June.

AIG’s bailout brings to about $900 billion the total of U.S. rescue efforts to stabilize the financial system and housing market in recent months. Authorities may get much of that sum back provided asset prices don’t
continue to slide, according to an AP analysis.

“It would have been a chain reaction,” Uwe Reinhardt, a professor of economics at Princeton University told the New York Times of the consequences of an AIG failure. “The spillover effects could have been incredible.”