Last week, the Federal Reserve made an unprecedented intervention into the private sector by agreeing to an $85 billion bailout for distressed insurance company American International Group. This decision was a significant change of course for the Federal Reserve, considering that it had resisted previous overtures from AIG for a loan or other federal intervention. Ultimately, the Federal Reserve believed that AIG — one of the world’s largest insurers — was too big to fall and its bankruptcy could trigger a worldwide financial crisis. See http://www.nytimes.com/2008/09/18/business/18insure.html?_r=1&pagewanted=2&oref=slogin.

The Federal Reserve’s decision was surprising to some given that it failed to intervene to rescue Lehman Brothers Holdings Inc. or to prevent the sale of Merrill Lynch to Bank of America. AIG’s potential collapse was different because of its role in providing “credit-default swaps,” which are contracts to investors designed to protect investors against default in an array of assets, including subprime mortgages. AIG’s bankruptcy would have forced investors around the world to devalue the securities protected by these credit default swaps, reducing the value of the investors’ assets. The Federal Reserve also appeared to be influenced by the possible effect on banks and mutual funds which had invested in AIG debt. See http://www.nytimes.com/2008/09/18/business/18insure.html?_r=1&pagewanted=2&oref=slogin.

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