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AIG rescue calms markets, HBOS and Lloyds in talks

17/09/08

By Douwe Miedema and Tony Munroe

LONDON/HONG KONG (Reuters) - An $85 billion dollar U.S. lifeline for American International Group gave some respite to battered financial stocks, while the UK's biggest mortgage lender HBOS Plc and Lloyds TSB contemplated a merger which would reshape British banking.

Shares in Britain's HBOS Plc were initially sharply lower for a sixth consecutive day on Wednesday, but recovered after a source familiar with the matter confirmed a report that it was in merger talks with Lloyds TSB.

Around the time the AIG deal with U.S. authorities was announced, British bank Barclays Plc gave markets another boost: agreeing to buy parts of Lehman for $1.75 billion.

The week has already seen the disappearance of two major Wall Street names, with Merrill Lynch throwing itself in the arms of Bank of America .

The cost of borrowing overnight dollars scaled the previous session's Libor fixing, indicating a deep lack of trust continuing to spook the inter-bank lending market after Lehman Brothers filed for bankruptcy protection.

Barclays stock rose 11 percent after the news it had bought a number of assets from Lehman, and major European stock indices were up between 0.4 percent and 1.3 percent.

Yet shares in Bank of Ireland dropped more than 9 percent after it said financial turmoil will hit its earnings and dividend, dragging other Irish banks down.

AIG RESCUE

The AIG rescue came just two days after U.S. authorities refused to rescue investment bank Lehman Brothers Holdings Inc , forcing it to file for bankruptcy protection despite pleas from Wall Street's chiefs.

AIG's lifeline bought time for investors to confront unprecedented financial turbulence which has altered the shape of Wall Street, but did little to ease a funding squeeze.

Asian stocks were mostly higher after Tuesday's dramatic selldown, with Tokyo's Nikkei index <.N225> up 1.2 percent and the MSCI Asia-Pacific ex-Japan stocks index <.MIAPJ0000PUS> up 0.9 percent. Oil rose more than $3 a barrel.

"Thank God," exclaimed Daniel Fuss, an influential bond manager who oversees more than $100 billion at Loomis, Sayles & Co in Boston. "AIG is interwoven with so many people and touches many companies around the world. This is a huge relief to many parts of the financial markets."

The Fed stepped in amid worries that a collapse of AIG could cause far-reaching damage to the global financial system, although some market players argued that the government's move brings just a short-term respite and could do long-term harm.

"What the U.S. government is doing is basically delaying the recovery of the economy really by keeping AIG alive and by going back to the printing press to issue more U.S. dollars, which long term should be negative to the U.S. dollar," said Ronald Chan, chief investment offer for Asian equities with Fortis Investments in Hong Kong, where he oversees about $1.5 billion.

On Tuesday, U.S. stocks had clawed back from their largest one-day drop in seven years on speculation about the AIG and Lehman deals. The two largest U.S. investment banks, Goldman Sachs Group Inc and Morgan Stanley , also reported better-than-expected earnings.

SENSITIVE TIMING

The rescue keeps AIG from surpassing Lehman as the largest U.S. corporate failure ever. It comes on the heels of a government bailout just over a week ago of mortgage finance companies Fannie Mae and Freddie Mac , and six months after the Fed helped to finance the fire sale of failed investment bank Bear Stearns to JPMorgan Chase & Co .

The move comes at a sensitive time given job losses and tax rates are key issues in the battle for the White House between U.S. Senators John McCain and Barack Obama.

AIG will pay interest at a steep 8.5 percentage points above the three-month London Interbank Offered Rate, equal to about 11.4 percent. That gives AIG a big incentive to embark on a massive asset sale program to pay back the loan quickly.

AIG's bailout brings to about $900 billion the total of U.S. rescue efforts to stabilize the financial system and housing market. Authorities may get much of that sum back provided asset prices don't continue to slide.

"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 Fed said in a statement.

AIG faced a cash crunch after $18 billion of losses over three quarters, largely because of complex securities that are tied to mortgages, and which plunged in value as the nation's housing crisis deepened.

Investors and credit rating agencies grew more doubtful that AIG could offset its losses with enough capital, which became prohibitively costly to raise as its share price plunged.

(Additional reporting by Jeffrey Hodgson and Kevin Plumberg; Editing by Lincoln Feast, Elaine Hardcastle and Alexander Smith)

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