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WASHINGTON (Reuters) - In one $85 billion fell swoop, the U.S. Federal Reserve may have wiped out what credibility it won resisting Lehman Brothers' rescue plea and opened its door to countless other companies to come calling for cash.
By providing a massive loan to American International Group on Tuesday, just two days after refusing to use public funds to save Lehman Brothers from bankruptcy, the central bank also invited tough questions on how exactly it determined whether a company was too big to fail.
Between the $29 billion the Fed pledged to swing the Bear Stearns sale to JPMorgan in March, $100 billion apiece to rescue mortgage finance firms Fannie Mae and Freddie Mac, up to $300 billion for the Federal Housing Authority, Tuesday's $85 billion loan to insurer AIG and various other rescue deals and loans, taxpayers are potentially on the hook for more than $900 billion.
"They pretended they were drawing a line in the sand with Lehman Brothers but now two days later they're doing another bailout," said Nouriel Roubini, a professor at New York University's Stern School of Business.
"We're essentially continuing a system where profits are privatized and...losses socialized," Roubini said, adding that auto makers, airlines and other struggling businesses would no doubt be asking for government help too.
The government was hard pressed to say no to AIG because of concerns that its collapse would harm thousands of companies around the world and cause chaos in the $62 trillion market for credit default swaps, where it is a big player.
Many on Wall Street were clamoring for a rescue earlier on Tuesday, and AIG's share price swung wildly throughout the day as rumors swirled of an on again, off again government rescue.
But Roubini said instead of handing out money to firms that made bad bets -- which could inadvertently encourage more risky behavior if companies think they have a safety net -- the government should be buying up mortgages and rewriting the terms so that households are not buried in debt.
To be sure, the Fed attached quite a few strings to its AIG funding deal. The loan carries a high interest rate, the government can veto any dividends, and AIG is expected to sell assets over the next two years to repay its debt. Senior management will be replaced.
But the central bank also followed a pattern established with Bear Stearns in March and repeated with Fannie and Freddie earlier this month of essentially wiping out shareholders while protecting those who held debt.
Some economists warned that investors had caught on and were betting on future bailouts by selling stock and buying bonds in struggling firms. That ends up pushing down a company's share price, which can exacerbate its troubles.
"If the message is that any time something like this pops up we're going to wipe out the equity and coddle the bondholders, that is its own sort of moral hazard," said Michael Feroli, an economist with JPMorgan in New York.
"I don't think you have to be a die-hard free market advocate to be at least a little bit concerned."
Fed officials said that they needed to act because of AIG's extensive involvement in financial markets. Through its insurance, risk and asset management businesses, AIG has dealings with many thousands of companies all over the world, so a bankruptcy would have had huge global repercussions.
RBC Capital Markets analyst Hank Calenti pegged the market impact of an AIG failure at more than $180 billion, or about half of the total capital that financial firms have raised since the beginning of the credit crisis last year.
But JPMorgan's Feroli said the Fed could have chosen to let AIG fail, just as it had done with Lehman.
"We don't know if the disease would have been worse than the medicine," he said. "We'll never know. But we know we lived through Lehman."
He said the central bank needed to clearly explain when and why it would act to salvage a company in jeopardy or face the prospect of a long line of companies seeking bailouts.
Fed Chairman Ben Bernanke, who has stayed out of the public eye during the Lehman and AIG drama, is due to testify before a congressional committee next week and can expect some pointed questioning, Feroli said.
"He needs to provide some sort of clear demarcation of what is or is not a systemic risk."
"Of the many unconventional actions taken by the Fed in the current crisis, this may likely prove to be the most controversial and should make Bernanke's...testimony on Capitol Hill an interesting event."
Editing by Jan Dahinten