The U.S. Federal Reserve Board has authorized the Federal Reserve Bank of New York to lend up to US$85 billion to the American International Group to prevent the insurance giant’s failure.

In exchange for the loan the U.S. government will take a 79.9% equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders. The loan is collateralized by all the assets of AIG and its subsidiaries, and is expected to be repaid from the proceeds of the sale of the firm’s assets. It has a 24-month term, and interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points.

In announcing the move Tuesday night, the Fed said it 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.”

“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,” it explained in a release.

Commenting on the deal, AIG’s board of directors issued a statement, explaining that it approved this transaction, “based on its determination that this is the best alternative for all of AIG’s constituencies, including policyholders, customers, creditors, counterparties, employees and shareholders.”

It notes that the company has over US$1 trillion in assets and substantial equity, but allowed that, “it has been recently experiencing serious liquidity issues.”

“We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis,” it says. “We expect that the proceeds of these sales will be sufficient to repay the loan in full and enable AIG’s businesses to continue as substantial participants in their respective markets. In return for providing this essential support, American taxpayers will receive a substantial majority ownership interest in AIG.”

US Treasury Secretary Henry Paulson, added, “These are challenging times for our financial markets. We are 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.”

Following the deal’s announcement, Fitch Ratings revised its Rating Watch on AIG to “evolving” from “negative”. Fitch said it views this transaction as a favourable development that alleviates significant near-term liquidity concerns.

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