Wall Street crisis: US Government launches $US85 billion bailout of insurer

The United States central bank is set to rescue ailing insurance giant American International Group with a package of $US85 billion in a desperate attempt to shore up confidence in the ailing US financial system.

The United States central bank is set to rescue ailing insurance giant American International Group with a package of $US85 billion in a desperate attempt to shore up confidence in the ailing US financial system.

While the US Federal Reserve and Treasury Secretary Henry Paulson were prepared to allow investment bank Lehman Brothers to fall into bankruptcy earlier this week, the Government has decided AIG was too big to fail.

“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 said in a statement.

The Government was forced to step in after a deal to the insurer by a group of Wall Street banks collapsed.

The US Government will receive warrants that could be exchanged for an ownership stake in AIG.

The move is likely to be extraordinarily controversial. Paulson said earlier this week that the Government was unwilling to continue to spend taxpayer money to prop up struggling financial institutions.

Yesterday, Republican presidential candidate John McCain said the Government should not bail out AIG because of “moral hazard”, believing financial services companies could take greater risks than they ordinarily would, safe in the knowledge that the Government will bail them out.

But Paulson and US Federal Reserve Chairman Ben Bernanke believe the bankruptcy of AIG would simply present too great a risk to the stability of global financial markets.

AIG’s financial crisis intensified overnight when its credit rating was downgraded, forcing it to find $US14.5 billion in collateral. While the insurer has far more than that in assets, it could not get the cash quickly enough to satisfy the collateral demands.

Despite the current equity market turmoil, Wall Street staged something of a recovery overnight as investors warmed to reports of the US Fed’s bailout of AIG.

The Dow Jones Industrial Average rose 141.51 points, or 1.3%, to 11,059.02, while the Standard & Poor’s 500 Index gained 20.90 points, or 1.75%, to 1213.60.

Earlier in the session, the US Federal Reserve had disappointed many market watchers by deciding to leave interest rates on hold. Many commentators expected the Fed to cut rates in a bid to stimulate the US economy.

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See also: What the Wall Street crises means for the Australian economy, interest rates and SMEs