* Treasury yields rise after Fed to take 80 pct stake in AIG
* Crude up $3, yen drops as some risky assets bought back
* Investors still cautious about unstable financial sector (Repeats to additional subscribers with no change to text) (Updates prices, detail)
By Kevin Plumberg
HONG KONG, Sept 17 (Reuters) - Asian stocks rose and oil was up $3 a barrel on Wednesday after the Federal Reserve said it would bail out American International Group in a dramatic about-face as victims of the financial crisis kept piling up.
After reports about the plan surfaced, investors bought back equities while selling the government bonds and yen they had accumulated in the wake of Lehman Brothers’ LEH.P filing for bankruptcy protection on Monday. However, the stock market rally across the region was still rather tame amid lingering fears about the banking sector.
Indications of fear in markets were elevated and evidence showed hoarding of U.S. dollars among banks, reflecting distrust rather than confidence.
The Fed will provide AIG (AIG.N), once the largest insurer in the world, a bridge loan of $85 billion and take an 80 percent stake in the ailing company, defusing the immediate risk of a financial system meltdown but burdening the U.S. taxpayer more following the government takeover of Fannie Mae and Freddie Mac about a week ago. [ID:nHKG15677]
The move was a surprise to some since the U.S. government had allowed Lehman to fail only days ago, suggesting how unstable markets have forced consumers, investors and policymakers alike to be flexible.
“I expect the markets will be a bit better today but that’s after a very rough period,” said Peter Hilton, head of Asia equity research with Royal Bank of Scotland in Hong Kong. “People were a bit worried about their effective savings. So relieving that pressure helps some,” he said.
Japan's Nikkei share average .N225 rose 2.1 percent after closing at a three-year low on Tuesday. Shares of Japan's top bank Mitsubishi UFJ Financial Group (8306.T) was lagging the broad market, up 1.5 percent.
The MSCI Asia-Pacific ex-Japan stocks index .MIAPJ0000PUS pared early gains and was up 1 percent at 0315 GMT, after hitting a two-year low on Tuesday. It is down 36 percent so far this year.
Hong Kong's Hang Seng index .HSI slipped 0.8 percent after an early rally fizzled because of persistent weakness in major bank stocks. Shares of HSBC (0005.HK), Europe's biggest lender, was the biggest drag on the index, followed by China Construction Bank (0939.HK), China's second-largest bank.
The rescue of AIG is the latest event in what has already been one of the most tumultuous weeks in the history of finance that has changed the face of the U.S. banking sector. Merrill Lynch MER.N agreed on Monday to be bought by Bank of America (BAC.N) for $50 billion.
Investors knocked the MSCI All-Country World equities index .MIWD00000PUS to the lowest since December 2005 on Tuesday as a flight from anything resembling risk in markets reached a fever pitch. The driving fear was a bankruptcy by AIG would trigger a catastrophic chain reaction of defaults in the global credit market.
AIG shares have plunged 94 percent year-to-date.
For a graphic, go to here
“If AIG had gone belly up, you would have an unknown, humongous number of default swaps cut off. What would that lead to? We were already approaching some market disruption,” said Dan Fuss, vice chairman of Loomis Sayles in Boston. “This is a huge relief to many parts of the financial markets.”
The U.S. dollar rose 0.9 percent against the yen to 106.26 yen JPY= after sinking to a four-month low of 103.54 yen on Tuesday. The euro EUR= was up 0.5 percent at $1.4186, boosted mainly by the 15-nation currency's 1.5 percent recovery against the yen to 150.77 yen EURJPY=.
Investors unloaded government bonds after the AIG rescue and in the wake of the Federal Reserve’s decision last night to keep interest rates on hold, spurning market expectations for a cut.
Two-year U.S. Treasury notes US2YT=RR fell 12/32 in price, driving yields up to 1.99 percent, from 1.79 percent late in New York on Tuesday. Yields on 10-year notes US10YT=RR rose to 3.56 percent, from 3.44 percent.
The December 10-year Japanese government bond future dropped a full point to 138.39 2JGBv1 after at one point on Tuesday hitting the upper trading limit, up 3 points.
Commodity prices rallied, lead by oil. The November U.S. light crude future was up $3.34 to $94.49 a barrel CLc1 after hitting a seven-month low on Tuesday, supported partly by supply disruptions after Hurricane Ike crashed into the Gulf of Mexico.
But the last-minute government rescue of AIG appeared to have neither ended the financial crisis, nor completely revived investors’ willingness to take risks.
The so-called TED spread of 3-month U.S. dollar borrowing rates used by large banks over the 3-month U.S. Treasury bill yield has risen a full percentage point in the last week to the widest of the year, as money markets effectively froze overnight.
The spread is often viewed as an indication of how much of a premium market participants are demanding to take risks.
“People are scared of further financial institution difficulty. Funding remains difficult and flows of risk-sensitive capital have slowed considerably,” said Patrick Bennett, Asia foreign exchange and interest rates strategist with Societe Generale in Hong Kong. (Editing by Lincoln Feast)