AIG Receives $85 Billion Loan From US Government

As I write this, there are reports trickling in that AIG (American International Group, ranked as high as the 18th largest company in the world by Forbes in 2008, known mostly for being an insurance company) has received an $85 billion dollar loan from the US Federal Reserve in exchange for a 79.9% ownership stake. AIG has been making headlines as it’s exposure to bad debt is so large that they were facing going out of business this week unless something could be done. Their share price has effectively fallen around 90% since the beginning of the credit crunch.

You may have heard that Lehman Brothers had announced it was filing for bankruptcy just a few days ago, which prompted the start of the week to be rather ugly. The complete failure of AIG was deemed to be too catastrophic for the financial system to bare, so the federal government has stepped in.

The Greenspan “Put”

This action by the US Federal Reserve to effectively bailout the markets is not all that rare. Alan Greenspan, the chairman of the US Federal Reserve for many years often dropped interest rates during times of market crisis. Lower interest rates generally bode well for financial markets for a few main reasons: 1) Cheaper access to money for everyone means they are more inclined to spend money on anything which improves profits of all business and 2) Cheaper access to money means investors have more money with which to buy stocks which increases buying pressure which props up prices.

The action of dropping interest rates to stem the decline of financial markets came to be known as “The Greenspan Put”. A “put” refers to “put options” which are a financial instrument that make money when markets go down – often used as a type of hedge or portfolio insurance. So if your investment goes down from $50 to $30, but you had a put option for $40, then you are pretty much guaranteed not to end up with less than $40 even if the original investment goes to $0. (That’s a very simplified version, but you get the picture.)

So the Greenspan Put was effectively a type of market insurance for everyone because the markets assumed that if things got really bad the “fed” (as it’s known for short) would step in and take steps to stop the losses.

As Greenspan handed over the reins to the now current chairman Ben Bernanke, we now hear the term the “Bernanke Put” being used. This latest lifeline from the government, while not in the form of lowering interest rates but rather as a loan in exchange for majority ownership is a similar manoeuvre.

Good or Bad?

One of the problems is that since everyone assumes that the fed will step in whenever things get really bad, the markets essentially have priced this in the form of higher prices and perhaps, higher risk taking overall.

If you are wondering about why the fed would choose to save AIG and not Lehman, consider this argument from Michael James on Money about how some businessesmust fail in order to maintain a healthy economy.