You break it, we own it

American International Group Inc. was the catastrophic failure the U.S. government wouldn't let happen. Instead, AIG emerged as Washington's largest-ever private sector bailout. For many, this amounts to de facto nationalization, although critics charge the government got too little in return. So far, Treasury and the Federal Reserve have forked over $150 billion in loans and cash, as they've fiddled with various approaches to steady the insurance giant and keep it from crushing others.

"Everything was improvised and panic," says financial analyst Yves Smith, author of the blog Naked Capitalism and an outspoken bailout critic.

The Fed got 80% equity in AIG, but, strangely, no board seat, and a promise to repay with interest. For that to occur, one of the world's largest insurers has to liquidate. The rescue was a way to forestall, but not prevent, dissolution. "At the end of the day, this is a lengthy divestiture process, a marathon, not a sprint," says Marshall Sonenshine, chairman and managing partner of investment bank Sonenshine Partners LLC. "AIG will cease to exist as an organization, or [be] a shadow of what it was."

Even that may be optimistic. "They're dealing with tens of billions of dollars that need to be paid back," says Gary Ransom, an analyst with Fox-Pitt Kelton Cochran Caronia Waller (USA) LLC. "They're selling in a market with very few buyers. I don't know if they can do it in the time they have."

The AIG rescue came Sept. 16, 2008, hours after Lehman Brothers Holdings Inc. went bankrupt and with markets in free fall. Many feared an AIG bankruptcy would cripple the global financial system and trigger knock-on failures that could reach cataclysmic proportions.

We'll never know how valid that fear was; the government's decision has been second-guessed since it was made. At the least, the rescue prevented AIG's counterparties against monumental losses. Those counterparties included major investment banks and extended into Europe and Asia. "The federal government found itself in an impossible position. Failure [of AIG] was a horrendous outcome to contemplate," says Sonenshine, who specializes in insurance-related M&A. But at the same time, a bailout meant "investing in a black box."

AIG collapsed because it peddled credit default swaps. Originally issued to insure against commercial debt defaults, CDSs became hugely popular as both a hedge and a bet against everything from mortgage-backed securities to collateralized debt obligations. AIG underwrote the business with a gusto bordering on gluttony, holding $527 billion worth by the end of 2007, on the belief there was no downside risk. Instead, in the months after the 2007 collapse of the subprime market, the insurer had to post billions of dollars of collateral on securitized assets whose value dropped rapidly. AIG faced billions more in losses if defaults forced it to buy the underlying assets.

AIG compounded its woes by lending securities short-term and receiving cash collateral in return. Instead of holding cash, AIG bought residential MBSs. When it came time to return the collateral, AIG was stuck. The market in residential MBSs had evaporated.

By early September, AIG stared at insolvency. Then Lehman collapsed.

One day later, the government moved in with an $85 billion, 24-month bridge loan from the New York Fed. In return, the Fed got warrants equal to 79.9% equity. The next month the government added $38 billion to buy some of its toxic assets. And still collateral calls kept coming. AIG ate through loans. The government substantially amended its original loan package less than two months after creation. The facility was reduced to $60 billion, with repayment terms extended to five years and a reduced interest rate.

AIG gained $40 billion more through the Troubled Asset Relief Program. The government offered another $50 billion to quarantine toxic assets. Under one facility, the government ponied up $30 billion, with an additional $5 billion from AIG, to buy at 50% of par CDOs and retire the underlying CDSs.

The Fed agreed to lend up to $22.5 billion to a new entity, which would buy and hold MBSs from AIG. In December, that entity bought $39.3 billion worth for $19.8 billion.

AIG's management promised asset sales to repay debt. That's tough in a good market, let alone one in which financing multibillion-dollar deals is nearly impossible. To date, AIG has sold a handful of units. The biggest: its Canadian life insurer, which got $308 million. There's now talk of spinning out units through initial public offerings. Good luck.