the fed has a choice -- don't do anything

When All Else Failed: Govt. Bails Out AIG to Avoid Catastrophe
Posted Sep 17, 2008 10:21am EDT by Aaron Task in Investing, Newsmakers, Recession, Banking
Related: FNM, FRE, LEH, AIG, XLF, ^DJI, JPM

Updated from 10:21 a.m. EDT

After saying this weekend it would not rescue AIG, the Federal government reversed course Tuesday evening and declared the insurance giant too big to fail.

The Fed pledged to lend AIG $85 billion over a two-year term at a rate of 8.5% plus LIBOR (or about 11.4% at current levels). The government is also taking a 79.9% stake in the company.

Initially, at least, the stock market gave a Bronx cheer to the Fed's actions as it becomes clear the Fed and Treasury are drawing a line in the sand as where/when they will intervene. In other words, traders are wondering what other financial firms might be dubbed "too small to save," as was the case with Lehman Brothers.

Update: Shortly before 12 pm EDT, the Dow was down about 300 points, or 2.7%, while the S&P and Nasdaq were each lower by 3.2%.

"Under ordinary circumstances, the market's role is to direct capital toward the most productive businesses at the expense of the weakest and least productive," writes Minyanville.com's Kevin Depew in an attempt to explain the market's harsh reaction. "As it stands, virtually every action being taken by authorities to intervene...is serving the purported goal of extending the process so that an orderly liquidation can ensue. This is having the unintended consequence of making capital for productive businesses very expensive or, in some cases, non-existent. In some respects the cure is worse than the disease."

Earlier:In taking this action Tuesday evening the Fed showed its concern about "systemic risk" -- as it had with Bear Stearns in March, and Fannie Mae and Freddie Mac earlier this month.

"The [Fed] 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," according to its statement.

In other words, the Fed was worried about a breakdown of the financial system and/or potential stock market crash had AIG been forced into bankruptcy, as seemed imminent barring this takeover of a totally private, non-bank entity.

Because this move is unprecedented in modern American history, and more taxpayer funds have been pledged the risk of unintended consequences remains high. But the Fed and Treasury felt as if they had no choice.