Fed Eschews Markets, Picks Winners and Losers in AIG, Lehman

By Craig Torres and Scott Lanman

Sept. 17 (Bloomberg) -- The Federal Reserve's decision to take over American International Group Inc. put it back into the game of picking winners and losers only two days after it left Lehman Brothers Holdings Inc. to bankruptcy.

The unrelenting credit crisis is forcing the Fed into ad-hoc decisions on whom to help, setting new precedents for investors as regulators threaten to crowd out the market's own risk and reward incentives to manage exposures to ailing companies.

``The government drew a line with Lehman and then erased a portion of the line'' with AIG, said Vincent Reinhart, former director of the Fed Board's Division of Monetary Affairs, now a resident scholar with the American Enterprise Institute in Washington. The loan ``does in fact raise issues about what the central bank is supposed to be doing.''

The Federal Reserve Board, with support of the U.S. Treasury, invoked emergency powers late yesterday to lend up to $85 billion to AIG after the insurer's losses on mortgage securities threatened to send it into bankruptcy. Lehman filed for bankruptcy Sept. 15 after Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson refused to offer funds.

The government will get a 79.9 percent equity interest in New York-based AIG. The stake is similar to the government's takeover of Fannie Mae and Freddie Mac earlier in the month, when it put the mortgage-finance companies into conservatorships in an effort to shield the home-loan industry from deeper damage.

Emergency Talks

AIG failed to raise private capital as its shares slumped, and held talks with bankers as well as Treasury and central bank officials at the New York Fed this week to craft a solution.

``This is very bad news and it is a very confused precedent,'' Adam Posen, deputy director of the Peterson Institute for International Economics in Washington, said in a television interview. ``AIG has been bleeding capital and liquidity for months. Anybody in their right mind could have gotten out.''

Fed and Treasury officials made a similar argument for avoiding aid for Lehman. They spurned help for the investment bank in talks at the New York Fed Sept. 12-14, saying Wall Street knew of its troubles for months, unlike the sudden collapse of Bear Stearns Cos. in March. The Fed then lent $29 billion against assets it still hasn't fully disclosed to secure Bear Stearns's takeover by JPMorgan Chase & Co.

`Middle of the Game'

``We are in a very bad situation,'' said Marvin Goodfriend, a former senior policy adviser at the Richmond Fed who is now professor of economics at Carnegie Mellon University's Tepper School of Business. As a central bank, ``you don't have any rules and you are trying to set the rules in the middle of the game.''

Wall Street bet billions that mortgages, which investment bankers wrapped into complex securities, would continue to pay. Now, nearly one in ten U.S. home loans is in delinquency or default in the wake of the subprime debacle and a weakening economy.

Fed officials have attempted to offset the credit crunch by pumping liquidity into markets and setting up new loan programs for commercial and investment banks. They also have reduced the benchmark interest rate 3.25 percentage points since September 2007. They left the benchmark rate at 2 percent, yesterday, rebuffing calls among some investors for a cut.

In the Bear Stearns, Fannie and Freddie cases, officials argued they were saving Main Street America from even more financial duress, not bailing out Wall Street. Some investors said late yesterday that even if AIG's rescue was a bailout, it was probably necessary.

`Disaster' Foreseen

``It would have been a disaster in the financial markets'' if AIG collapsed, said Eric Hovde, chief investment officer at Hovde Capital Advisors LLC in Washington. ``The simple fact is that AIG is so huge, so large, with so much counterparty risk'' in the market for insurance against credit defaults, he said.

Fannie and Freddie, along with 12 federal home loan banks, have accounted for 70 percent of the financing for new U.S. mortgages this year, meaning their failures threatened to send the housing market into depression.

Paulson attempted to shore up confidence in the companies in July by getting authority to inject capital into them as needed.

The move backfired. After President George W. Bush signed the legislation July 30, Fannie and Freddie shares kept falling because investors were spooked by the prospect that government intervention could dilute their money. Five weeks later, Paulson engineered a takeover of the companies.

Bigger Rescue

Now, some Democrats are pushing for an economy-wide rescue package.

The ``next question'' for lawmakers and economic policy makers will be whether Congress should create an agency like Resolution Trust Corp., which took over the assets of failed savings and loan associations two decades ago, House Financial Services Committee Chairman Barney Frank said Sept. 15.

``The better message'' is to oppose rescues, Senator Richard Shelby of Alabama, the senior Republican on the Senate Banking Committee, countered in a Bloomberg Television interview. ``Is that brutal? Yes. But it is market economics.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net.; Scott Lanman in Washington at slanman@bloomberg.net