11:15PM New York – The U.S. Treasury and the Fed engaged in the largest nationalization in the U.S. history and seized AIG and in exchange extended $85 billion in emergency loans.

The Federal Reserve Bank nationalized the troubled insurer AIG, fired its management and offered up to $85 billion of loan at a substantially higher rate than expected. The dramatic decline of once the largest insurance companies in the world highlights the daunting tasks the regulators in Washington and New York face in restoring investors’ confidence.

What is more shocking to most free market disciples is the country that preaches the virtues of market forces carried out the largest bailout in the recent history. During the times of Korean financial crisis, Asian contagion and Russian currency meltdown the U.S. offered financial assistance only under a condition that local banks must be allowed to fail. The U.S. financial assistance often came with unwanted free markets ideological sermons.

The Fed will provide two-year bridge loan to the insurer at 8.5% above the Libor rate and in exchange of warrants that will control 79.9% of the company and replaced its management. The Fed action is nothing short of nationalization, the word that most Washington free market pundits in the current administrations will not utter. The Fed hopes that its action will allow AIG to conduct its business and sell assets in an orderly manner in less than two years and repay loans.

Regulators Dilemma

The nationalization of AIG is the worst financial collapse in the recent U.S history and largest bailout of any private company in the world. The lawmakers and regulators remain at odds as late as last night before the announcement of bailout. The U.S. Treasury Secretary office and the Senate Finance Committee members could not agree on how far the U.S. gets involved in AIG and in the future collapses of other financial institutions and companies in other industries.

Events in financial markets are moving at a much faster pace than regulators in New York and Washington can get their arms around. The money market funds held by millions of investors and savers around country have exposures to bonds issued or insured by AIG. The money market fund, which most people consider as safe as the U.S. government bonds or cash in checking account may fall below its par value and could effectively start a run in the financial system. The Fed, cognizant of this, to prevent a systemic failure and maintain confidence in the financial markets acted swiftly and lent whopping $85 billion to AIG. Obviously, at a cost to the shareholders who stand to be wiped out as in the case of Bear Stearns, Fannie Mae and Freddie Mac.

Reserve Primary Fund, the oldest U.S. money market fund suspended withdrawals for seven days after the value of its fund fell below $1 nominal value. The so called ‘breaking the buck’ is a rare occurrence and generally forces investor to seek other liquid and safer funds. In the last two days, after the collapse of Lehman Brothers, shareholders withdrew $38 billion of $64.8 billion from the fund. The Fed, mindful of this development wanted to prevent such a run on a much larger scale across the country.

Moral Hazard Precedent

AIG is not out of the woods yet and it is not clear how and when the U.S. will receive its capital back. The regulators are working with AIG to restore the confidence of its customers and policy holders and provide a much needed liquidity to the company. The new capital will help AIG to continue its operations and offer much needed time to sell its asset at market price. Many businesses owned by AIG are healthy an several competitors are interested in acquiring pieces of the business.

AIG is actively engaged in selling several assets including its aircraft leasing unit and international insurance subsidiaries in Japan and Taiwan may be sold. However, the U.S. government may get deeply enmeshed in the company’s rescue if the housing market continues to fall, the root cause of the current troubles at AIG.

There are still no visible signs that indicate that the housing market is near bottom or ready to stabilize. The AIG problems are rooted in the mortgage insurance obligations that the insurer issued, many of them tied to the riskier mortgages. The company underwrote credit default swaps protections, private contracts written for individual mortgages or for the portfolio of loans which are largely outside the control of the U.S. regulators.

They are the invisible oxygen that every institutional investor relied on and did not worry about. Most investors did not want to think nor had the grasp of the intricacies of the fall out if their insurance companies, that guaranteed these contracts failed, especially those rated highly by the rating agencies.

More Troubles Ahead

The AIG’s derivative exposure is largely undetermined. Analysts and management can estimate the size of the losses but it’s a moving target. The company in the last two quarters has declared $18 billion in losses but still has exposure to risky contracts worth more than $410 billion. If the largest insurance company in the U.S. which supposedly has $1 trillion in assets can be brought to its knees with less than $20 billion in losses linked to housing market debacle, one can only imagine what will happen 1 million more homeowners file for foreclosure in the next one year.

What is still not clear is that how is it possible that a company with $1 trillion in assets cannot come up with $70 billion in cash. The need for cash only weeks ago was less than $10 billion which morphed into emergency demand of $85 billion in less than four weeks. And why should taxpayer bailout a company that was once one of the richest companies in the world?

What will happen if housing market falls further and losses in the financial system mount and the U.S. Congress in its utter wisdom cannot decide which way to turn? The current AIG bailout only covers the losses of the past and has no provision for the future losses. If housing market drops mere 10% in the next two quarters, that will automatically create rating downgrades which will generate a new cycle of losses at AIG and at many other banks.

In that event if another $50 billion loan is needed in the next six months by AIG, will the U.S. Congress and Treasury be ready with another emergency loan or will AIG be allowed to fall? As the current financial crisis deepens and broadens, the cost of bailout will only rise. According 123jump.com compilation global banks and financial institutions have declared $515 billion of losses since the credit market crisis began in June 2007 and most economists are now estimating total losses could run as high as $1 trillion. What will be the Fed’s response when the next time around another bank or insurance company asks for $100 billion, a number that most common man cannot even fathom?

With two simultaneous bailouts of Fannie and Freddie and AIG orchestrated by the Treasury Secretary Henry Paulson and free market preachers in the Bush administration, the U.S. is now the largest mortgage lender, insurer and foreclosed home owner. And, with what moral authority will the U.S. lecture China, India and other emerging nations on the virtues of free markets and with what moral compass will it advise European nations to stay away from the next government intervention when their crown jewels are faltering.