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Another Day. Another Fed Bailout

POSTED: September 17, 2008, 12:00 am

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As the financial markets continued to teeter after a whirlwind weekend that saw Lehman Brothers face bankruptcy and Bank of America announce it would acquire brokerage house Merrill Lynch, the Federal Reserve Board met and decided against adjusting the key overnight federal funds rate in an attempt to calm the market. To keep the funds rate at its target, the Fed pumped an additional $50 million in cash into the market. Despite its decision to keep the interest rate at 2 percent, the Fed was active in a frantic behind the scene effort to help stave off another collapse; this time it was financial giant American International Group (AIG) on the brink of bankruptcy.

Over the weekend AIG announced it would seek a $40 billion bridge loan from the federal government to shore up its capital. With the federal government having just seized Fannie Mae and Freddie Mac one week ago and rejecting a plea for help from Lehman Brothers, the initial reaction to AIG’s appeal was cool. In fact, the Fed first sought to broker a deal between several financial firms to secure the funds for AIG. When a deal could not be made, it was beginning to look as though AIG’s only option was to file Chapter 11 bankruptcy; a move that could almost be guaranteed to shake consumer and investor confidence.

Sensing the potential fallout the Fed announced Tuesday that it would provide an $85 billion loan package for AIG under Section 13(3) of the Federal Reserve Act. In a statement the Fed announced,

“The Board 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.”

The terms of the loan gives the federal government a79.9 percent equity stake in AIG and the right to veto the payment of dividends to common and preferred shareholders. AIG’s assets, including the stock of most of most of its subsidiaries, serve as collateral for the loan. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets.

This latest move may do little toward restoring investor confidence in the financial markets. The implosion that occurred last weekend and the litany of bad news that is in print, on television and on radio has, by effect, cast a dark cloud over the economy. Though select industries have managed to maintain some degree of stability, and a few such as in health care and technology, have been strong; the economy’s downward slide has been far reaching. Last month’s Bureau of Labor Statistics Employment Situation Summary out of the Department of Labor showed that in August the nation’s unemployment rate hit a five year high. When considered against the backdrop of the home foreclosure crisis prompted by the collapse of the alternate rate mortgage market, the drumbeat of bad news has numbed the country.

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