AIG Bailout II -- Why Are the Feds So Generous?

(MoneyWatch)  The federal government appears to be bending over backwards to satisfy American International Group.
After bumping up its original bailout plan repeatedly, the feds have come up with a whole new deal with easier payment terms and even more money.

AIG will get a plan worth $150 billion instead of the $123 billion package approved before. The earlier plan also included another $20 billion from a separate government fund. Some $85 billion in a two-year loan will be replaced by a $60-billion, five-year loan at lower interest rates. Treasury will buy $40 billion of preferred AIG stock.

Two separate funds totaling $52.2 billion will be set up to help AIG rid itself of troubled assets, including real estate and Collateralized Debt Obligations (CDOs). The government will contribute $22.5 billion to one fund with AIG contributing $1 billion. The New York Federal Reserve will provide $30 billion into a second fund with AIG putting in $5 billion.

The latest AIG bailout is certain to spark controversy. Democrats in Congress will use the latest bailout as ammunition for a massive federal rescue of the U.S. automobile industry. Some Wall Streeters are scratching their heads as to why the government is being so good to AIG when it let another big lender, Lehman Brothers, go bankrupt.

For some insight of how AIG got into such a mess, read Gretchen Morgenson's post mortem of another failed Wall Street giant, Merrill Lynch, in Sunday's New York Times. She points out that Merrill Lynch didn't have much exposure to shaky derivatives such as CDOs before 2002 but pressure to pile up new earnings launched the venerable investment house into strange new territory.

By 2006, without much of a plan in hand, Merrill Lynch had become the world's largest writer of CDOs. For a while, AIG underwrote most of them. In 2005, however, AIG was getting skittish about insuring so much housing debt and backed out. That sent Merrill Lynch on a long plunge from which it didn't recover. The firm is being taken over by Bank of America.

AIG, of course, had its hands in all types of obligations and it too got into deep trouble. It has posted losses of $37.6 billion for the first nine months of this year.

The script has been the same at other institutions including Wachovia and National City. Healthy bankers got greedy and dove into exotic, little-understood derivatives based on weak mortgages. At least AIG executives won't be benefiting. As part of the latest rescue, the top five officials at AIG will have strict restrictions on their compensation.