Just a little over nine years since the the federal government gave the American International Group Inc. — better known as AIG (NYSE:AIG) — a bailout of $85 billion, the U.S. Financial Stability Oversight Council (FSOC) decided that financial distress at the insurance giant no longer posed a threat to U.S. financial stability. The Council voted to remove AIG from a list of systematically risky institution, often known as those that are 'too big to fail.' 

Removal from this status would mean AIG is now free from supervision from the Federal Reserve's Board of Governors and strict prudential standards including tougher capital requirements.

On September 16, 2008, in exchange of the money it pumped into the company, the U.S. government received nearly 80% of the firm's equity. For decades, AIG was the world's biggest insurer, a company known around the world for providing protection for individuals, companies, and others. But in September, the company would have gone under if it were not for government assistance.

Read on to learn what caused AIG to begin a downward spiral and how and why the federal government pulled it back from the brink of bankruptcy.

High Flying

The epicenter of the near-collapse of AIG was an office in London. A division of the company, called AIG Financial Products (AIGFP), nearly led to the downfall of a pillar of American capitalism. For years, the AIGFP division sold insurance against investments gone awry, such as protection against interest rate changes or other unforeseen economic problems. But in the late 1990s, the AIGFP discovered a new way to make money.

A new financial tool known as a collateralized debt obligation (CDO) became prevalent among large investment banks and other large institutions. CDOs lump various types of debt—from the very safe to the very risky—into one bundle. The various types of debt are known as tranches. Many large investors holding mortgage-backed securities created CDOs, which included tranches filled with subprime loans

The AIGFP was presented with an option. Why not insure CDOs against default through a financial product known as a credit default swap? The chances of having to pay out on this insurance were highly unlikely, and for a while, the CDO insurance plan was highly successful. In about five years, the division's revenues rose from $737 million to over $3 billion, about 17.5% of the entire company's total. (Read Credit Default Swaps: An Introduction to learn more about the derivative that took AIG down.)

One large chunk of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches comprised of subprime loans. AIG believed that what it insured would never have to be covered. Or, if it did, it would be in insignificant amounts. But when foreclosures rose to incredibly high levels, AIG had to pay out on what it promised to cover. This, naturally, caused a huge hit to AIG's revenue streams. The AIGFP division ended up incurring about $25 billion in losses, causing a drastic hit to the parent company's stock price. (Read more about the lead-up to the credit crunch in The Fuel That Fed The Subprime Meltdown.)

Accounting problems within the division also caused losses. This, in turn, lowered AIG's credit rating, which caused the firm to post collateral for its bondholders, causing, even more, worries about the company's financial situation.

It was clear that AIG was in danger of insolvency. To prevent that, the federal government stepped in. But why was AIG saved by the government while other companies affected by the credit crunch weren't? (Read about one company that didn't survive financial crisis in The Rise And Demise Of New Century Financial.)

Too Big To Fail

Simply put, AIG was considered too big to fail. An incredible amount of institutional investors — mutual funds, pension funds and hedge funds — both invested in and also were insured by the company. In particular, many investment banks that had CDOs insured by AIG were at risk of losing billions of dollars. For example, media reports indicated that Goldman Sachs Group, Inc. (NYSE:GS) had $20 billion tied into various aspects of AIG's business, although the firm denied that figure.

Money market funds—generally seen as very conservative instruments without much risk attached—were also jeopardized by AIG's struggles, since many had invested in the company, particularly via bonds. If AIG were to become insolvent, this would send shockwaves through already shaky money markets as millions of investors — both individuals and institutions — would lose cash in what were perceived to be incredibly safe holdings. (To learn more about the rough times money market funds saw, read Why Money Market Funds Break The Buck.)

However, policyholders of AIG were not at too much risk. While the financial-products section of the company was facing extreme difficulty, the vastly smaller retail-insurance components were still very much in business. Also, each state has a regulatory agency that oversees insurance operations, and state governments have a guarantee clause that will reimburse policyholders in case of insolvency.

While policyholders were not in harm's way, others were. And those investors — from individuals looking to tuck some money away in a safe investment to hedge and pension funds with billions at stake - needed someone to intervene.

Stepping In

While AIG hung on by a thread, negotiations were taking place among company and federal officials about what the next step was. Once it was determined that the company was too vital to the global economy to be allowed to fail, the Federal Reserve struck a deal with AIG's management to save the company.

The Federal Reserve was the first to jump into the action, issuing a loan to AIG in exchange for 79.9% of the company's equity. The total amount was originally listed at $85 billion and was to be repaid over two years at the LIBOR rate plus 8.5 percentage points. However, since then, terms of the initial deal have been reworked. The Fed and the Treasury Department have loaned even more money to AIG, bringing the total up to an estimated $150 billion. (Learn how these two agencies work to stabilize the economy in tough times in The Treasury And The Federal Reserve.)

The Bottom Line

AIG's bailout has not come without controversy. Some have criticized whether or not it is appropriate for the government to use taxpayer money to purchase a struggling insurance company. Also, the use of the public funds to pay out bonuses to AIG's officials has only caused its own uproar. However, others have said that, if successful, the bailout will actually benefit taxpayers due to returns on the government's shares of the company's equity.

No matter the issue, one thing is clear. AIG's involvement in the financial crisis was important to the world's economy. Whether the government's actions will completely heal the wounds or will merely act as a bandage remedy remains to be seen.

To learn more about bailouts such as this one, be sure to read our related article, Top 6 U.S. Government Financial Bailouts.