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Market Crisis: All Eyes on AIG

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New York, NYThe worst crisis to hit the financial markets since 9/11 could potentially spiral even deeper with the threat to American International Group Inc. (AIG), the insurance giant that was downgraded yesterday. All eyes are now on AIG, to see if Monday's shock that saw the bankruptcy of the 135-year-old Lehman Brothers Bank, and the sale of venerable Merrill Lynch to Bank of America, widens still.

"If AIG goes under, there could be a domino effect,'' said Andrea Cicione, a credit strategist at BNP Paribas SA in London, speaking to Bloomberg News. "AIG is very connected to the financial system and it is very connected to the real economy.''

Market CrisisAIG remains the nation's largest insurer by assets. However, the posting of an $18 billion combined loss over the previous three quarters prompted the rating cut, forcing the insurance juggernaut to scramble for up to $75 billion in loans to cover its liabilities. The company also may have to post as much as $17 billion in collateral as a result of the downgrading.

The AIG blockbuster comes on the heels of one of the most difficult days on the markets since the Great Depression. Lehman Brothers, one of the nation's oldest banks and in existence since before the Civil War, found itself like so many others drowning in the backwash of sub-prime mortgages. Expected suitors came and went, and at the end of the day even the Feds declined to help, as it had with Fannie Mae and Freddie Mac, and Bear Stearns before it. Analysts say that the credit crisis is so widespread that the Fed couldn't rescue everybody, and that somebody had to be allowed to go down. Lehman, after failing to secure a buyer, took the fall. Together with the troubles of venerable Merrill Lynch, saved from extinction by Bank of America, the shock contributed to a drop of more than 500 basis points on the DOW yesterday, a corresponding drop at the TSE in Toronto, and a softer world market when the rest of the globe awakened this morning.

Now, less than 24 hours after analysts thought it couldn't get any worse, it just might with AIG.

Analysts fear that if AIG is not successful in raising cash, it too could file for bankruptcy. Goldman Sachs and JPMorgan Chase are the point men for arranging up to $75 billion, and they are in talks with the Federal Reserve. It is unclear, however if the Fed, having left Lehman Brothers to fall, will aid in the rescue of AIG. It was reported that AIG had requested from the Fed $40 billion in bridge financing at the beginning of business Monday morning. The Fed refused, given the fact that its mandate is to oversee banks, not insurers. By the end of the day that figure had grown to $75 billion after rating downgrades by Moody's and Standard and Poor's.

It should be noted that while most of AIG's business interests are healthy, the downgrading stemmed from a unit that dealt in complex debt securities and derivatives. AIG finds itself stuck with similar exposure to the same mortgage-linked debt securities that precipitated the fall of Lehman Brothers.

Meanwhile shares in AIG dropped more than 60 percent Monday. Governor David Paterson of New York, referring to the situation as "dire," announced yesterday that the State had extended AIG permission to borrow up to $20 billion in capital from its own subsidiaries.

"I hope you're aware of the risks if we don't act," he told journalists at a midday news conference. "It is a systemic problem."

Talks between AIG and regulators go back to last week, after Lehman Brothers appeared to be threatened. Given that AIG's financial unit in London had equal exposure to doomed debt securities as Lehman, it feared that the failure of Lehman could also spell disaster for AIG. Analysts maintain that such a failure of a counterparty, which is what Lehman was, represents uncharted territory in the modern financial world. The failure of another counterparty such as AIG could foster a domino affect around the globe.

A counterparty is an entity which shares a relationship, and therefore liability within derivatives contracts held by a number of other financial institutions.

"It's not just the failure of one company," said Julie A. Grandstaff, vice president and managing director of StanCorp Investment Advisers, in published comments appearing in the New York Times. "It's the ripple effect of the disappearance of counterparties" that was driving such urgent efforts to bolster A.I.G. Financial officials fear another failure of a big counterparty could start a chain reaction.

Thus, the race to shore the enterprise up. However, the mandate of the Fed to ride shotgun over the banking, and not the insurance industry, may dictate whether or not it becomes involved—not to mention the precedent that might be set were it to break with its mandate and participate in the rescue of AIG.

As the clock ticks, all eyes are glued to AIG, with frequent sideward glances to the markets. All agree that AIG can't be allowed to fail, as Lehman Brothers was allowed to do.

If it does, no one has any idea what to expect. Few expect it to be good.

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