Sept. 17 (Bloomberg) -- The U.S. government took control of American International Group Inc. in an $85 billion bailout to prevent the bankruptcy of the nation's biggest insurer and the worst financial collapse in history.

The Federal Reserve will provide a two-year loan, take 79.9 percent of the New York-based company's stock and replace its management because "a disorderly failure of AIG could add to already significant levels of financial market fragility,'' according to a statement by the central bank late yesterday.

AIG unraveled as the worst housing crisis since the Great Depression led to more than $18 billion of losses in the past year. A meltdown could have cost the financial industry $180 billion, according to RBC Capital Markets, because AIG provided insurance on more than $441 billion of fixed-income investments held by the world's biggest institutions, including $57.8 billion in securities tied to subprime mortgages.

Nobody really knows what it would have meant if they would have been allowed to fail, but there was an enormous amount of systemic risk,'' said David Havens, a credit analyst at UBS AG in Stamford, Connecticut. It's an enormous relief.''

The government is lending AIG the money at 8.5 percentage points above the three-month London interbank offered rate, or a current rate of about 11.5 percent.

The agreement will give the company, which sells insurance in more than 130 countries, time to sell assets "on an orderly basis,'' AIG said in a statement. Chief Executive Officer Robert Willumstad, 63, will be replaced by former Allstate Corp. CEO Edward Liddy, 62, according to a person familiar with the plans, who declined to be identified because the change hadn't been formally announced.

Shares Fall

AIG dropped 45 percent to $2.05 at 4:15 p.m. in New York, after falling 80 percent in the past week on concern the company would go bankrupt. The seizure in credit markets and more than $500 billion of losses related to subprime mortgages forced the government to take over Fannie Mae and Freddie Mac, which control about half of America's $12 trillion in home loans, and drove Lehman Brothers Holdings Inc. out of business.

"I am floored,'' said former Treasury counsel Peter Wallison in an interview. "No one could have possibly imagined this a few months ago. I can't imagine why the Fed would do this unless they were sure AIG's failure posed systemic risk.''

Credit Downgrades

The survival of the 89-year-old insurer fell into doubt when Standard & Poor's and Moody's Investors Service cut its credit ratings on Sept. 15. The reductions threatened to force AIG to post more than $13 billion in collateral when the company was already short on cash. AIG couldn't raise money by selling shares after the stock plunged to less than $4 a share from $70.11 in October of last year.

"There could be a greater need for capital'' beyond the $85 billion, New York Insurance Superintendent Eric Dinallo told CNBC today, adding that the loan will give AIG time to sell units.

The loan will "be sufficient to handle AIG's collateral needs'' and allow the insurer to refinance debt as it comes due, said Wachovia Corp. analyst John Hall in a note today.

The Fed's loan doesn't require asset sales or the company's liquidation, though these are the most likely ways AIG will repay the Fed, central bank staff officials told reporters on condition of anonymity. Blackstone Group LP advised AIG on the transaction.

'Punitive' Interest Rates

The "punitive'' interest rate on the loan "makes it extremely clear that this is not a subsidy extended to keep the company afloat but rather a stranglehold that makes AIG unviable while ensuring that its obligations will be met,'' said Marco Annunziata, an analyst at UniCredit SpA, in a note to clients. "This is to all extents and purposes a controlled bankruptcy.''

The Fed doesn't have an expectation of whether AIG will be smaller, nonexistent or similar to its current form at the end of the loan's term, the staffers said.

The Fed or Treasury will end up holding the AIG stake, the staffers said. The Fed bailed out AIG while refusing aid to Lehman, which collapsed earlier this week, because financial markets were more prepared for a Lehman failure, a Fed staff official said.

The Fed stepped in after JPMorgan Chase & Co. and Goldman Sachs Group Inc., which were brought in to help assess AIG, failed to come up with a solution, according to a person familiar with the talks. Liddy is currently on the board of Goldman, the company Henry Paulson ran as CEO before becoming the U.S. Treasury secretary in 2006.

CEO Turnover

Willumstad, the former Citigroup Inc. president who left the bank in 2005 to seek a CEO position, was named to AIG's top post in June. His predecessor, Martin Sullivan, was chief for three years until being ousted after two record quarterly net losses. Maurice "Hank'' Greenberg reigned at AIG for almost four decades until he was forced to retire in 2005 amid regulatory probes.

Greenberg, who remains one of the company's biggest stakeholders, said the company needed a bridge loan instead of a plan that put the company under government control. An investor group led by Greenberg said in a federal filing hours before the rescue was announced it might want to buy the company or some units or make loans to AIG.

"Why would you want to wipe out shareholders when you just need a bridge loan?'' Greenberg, 83, said in an interview before the announcement. "It doesn't make any sense.'' Greenberg declined to comment after the Fed announcement, spokesman Glen Rochkind said.

Banks, Annuities

Businesses that may be sold include American General Finance Corp., the division that makes home and auto loans, said Citigroup analyst Joshua Shanker. The unit generated $2.89 billion in revenue last year, about 2.6 percent of AIG's total. Other candidates include AIG's U.S. variable-annuity business, and a 59 percent stake in reinsurer Transatlantic Holdings Inc., he said.

Asset manager AIG Investments, with 5.1 percent of AIG's revenue, could also be sold, said Gary Ransom of Fox-Pitt Kelton Cochran Caronia Waller.

American General Finance's price could be more than $6 billion if the unit sold for twice its book value. AIG Investments could fetch more than $3 billion if it sold for 2.5 percent of clients' assets under management. The Transatlantic stake is worth about $2.3 billion, based on yesterday's share price. The variable annuity results aren't broken out, making an estimate difficult, said Shanker. AIG acquired the business a decade ago when it bought SunAmerica for $19.7 billion in stock.

Aircraft Leasing

AIG's aircraft-leasing unit International Lease Finance Corp. may be bought by investors led by the unit's founder, Steven Udvar-Hazy, the Wall Street Journal reported, citing unnamed people. Udvar-Hazy has been in discussions with potential investors since Sept. 14, the Journal said.

AIG may also find buyers for life insurance outside the U.S. where competitors including Hartford Financial Services Group Inc., MetLife Inc., Prudential Financial Inc., and Canada's Manulife Financial Corp. have been adding customers.

"In developing insurance markets around the world, the growth rates are, on average, twice what the growth rates in the U.S. are,'' MetLife Chief Financial Officer William Wheeler said Sept. 10. "When properties come up for sale around the world, it's very competitive.''

Car Insurance

Auto insurers are also consolidating, making AIG's car unit a takeover candidate. Liberty Mutual Group Inc. agreed in April to buy Safeco Corp. for $6.2 billion, the U.S. industry's biggest transaction since 2004.

AIG rejected a bid for a joint investment by Allianz SE and J.C. Flowers & Co. on Sept. 14, said two people with knowledge of the offer.

Allianz, Europe's biggest insurer, and Flowers, the New York-based private equity firm run by J. Christopher Flowers, proposed the cash infusion to help AIG fend off a liquidity crunch, the people said.

Sabia Schwarzer, an Allianz spokeswoman, declined to comment. Flowers and Nicholas Ashooh, an AIG spokesman, didn't return calls seeking comment.

------------------------------------------------------------------------------

Copyright 2008 Bloomberg L.P. All Rights Reserved.