ANALYSIS:Credit default swaps and not insurance deals made AIG keel over into the arms of the Fed, writes Arthur Beesley

THE TENTACULAR reach of AIG's vast business interests was a crucial factor when the US Federal Reserve came to rescue the troubled company on Tuesday night as it faced the prospect of insolvency due an acute funding crisis.

In return for an $85 billion loan on onerous terms, the US government has taken a 79.9 per cent stake in the firm. Assets will be sold to help the government recoup its money.

That this is a humiliation for AIG, once considered to be the arch insurer, is a given. The fact the US authorities executed the deal at all underlines the severity of the crisis, which seems to deepen by the hour these days as more and more titans of the international scene fall by the way.

Many leading Wall Street firms and big-league organisations in Europe and Asia had protection from AIG to guard their investments against potential bankruptcies. Any collapse of AIG, which does business in as many as 100 countries, would have triggered chaos as clients sought alternative insurance.

Best-known in Ireland for its successful commercial insurance business, AIG continues to control a valuable international insurance franchise. The firm's journey to the brink of the abyss this week stems not from those operations, but from its entry into the derivatives market in the 1980s.

A unit called AIG Financial Products wrote billions of dollars of derivatives with the help of the firm's "triple A" credit rating, making it an attractive counterparty for swap transactions.

AIG entered the market for credit default swaps, which insure against the risk of default, and insured against defaults on pools of securities called collateralised debt obligations (CDOs). Many deals it underwrote were in the "super-senior" category, meaning they had a triple-A rating.

AIG's appetite for this form of risk worked well when defaults were rare, but it proved utterly disastrous as the credit crunch wormed its ruinous way through the financial system, leading ultimately to sharp write-downs in those assets. Having taken write-downs totalling $41 billion, AIG was in need of an additional $75 billion when the Fed capitulated.

Tim Geithner, the New York Fed chief skipped the Fed policy meeting on ­Tuesday to try to hammer out a deal. Treasury secretary Hank Paulson - who had taken a hard line on no public support for Lehman - was reluctant to put taxpayer money at risk only days later and insisted on punitive terms for AIG shareholders and management, modelled on the Fannie Mae and Freddie Mac takeover.

Mr Geithner presented these terms to AIG: $85 billion at a punitive interest rate; the existing management must go; the government would take rights to 79.9 per cent of AIG equity and assume veto authority over all big ­decisions. There was no negotiation.

As volatility engulfs the global system, the company is now locked in a fateful embrace with the lender of last resort.

- (Additional reporting Financial Times)