American International Group will get an $85 billion bridge loan from the federal government in exchange for an 80 percent stake in itself, sources have told CNBC.
Sources said the loan, which will allow AIG to avoid bankruptcy, will be secured and include incentives for quick asset-sales by AIG.
Government warrants for most of AIG’s equity will severely dilute existing shareholders.
AIG has been racing the clock to avoid a bankruptcy filing on Wednesday, making efforts to work out a deal with the Federal Reserve to shore up its finances.
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke met with Senate and House leadership Tuesday night to discuss how to assist AIG, sources said.
The Fed's financial aid to the troubled insurer marks a reversal of its decision on Monday to refuse a bridge loan to AIG.
The Fed met with the company's advisers throughout the day and came to a better understanding of what is needed to help the company through its current crisis, people familiar with the negotiations told CNBC.
Bloomberg reported late Tuesday that the Fed was considering some kind of conservatorship for AIG—which would mean bringing in an outsider to run the company. But sources told CNBC that no legal authority exists for such an arrangement.
AIG shares swung wildly all day Tuesday in heavy volume.
Watch David Faber's report on possible AIG deal.
The shares, which are a component of the Dow Jones Industrial Average, at one point were down more than 50 percent in the wake of a cut in the insurer's credit rating, which only served to heighten the concerns that it would file for bankrupcy and further upset the troubled global financial system.
The plunge in AIG shares has been the biggest drag on the Dow this week.
AIG, one of the world's largest insurers, is the latest company to be convulsed by a mortgage and credit crisis that this week led to a bankruptcy filing by Lehman Brothers Holdings and the sale of Merrill Lynch to Bank of America.
WALL STREET IN CRISIS - A CNBC SPECIAL REPORT
AIG late Sunday asked the Federal Reserve for help, including a possible "bridge" loan to tide it over while it pursues asset sales and capital raising. The Fed refused, but pushed JPMorgan Chase and Morgan Stanley to try to put together a credit facility of $70 billion to $75 billion for New York-based AIG, a person familiar with the matter said on Monday.
Paulson View Unchanged
The Fed declinded to comment Tuesday on its willingness to assit AIG.
However, a Treasury official told CNBC that the comments of Treasury Sectary Hank Paulson on Monday still stand.
On Monday, Paulson had said, "We do not take, and I don't take, lightly ever putting the taxpayer on the line to support an institution ... Don't read it as no more; read it as that it's important, I think, for us to maintain the stability and orderliness of our financial system. Moral hazard is something I don't take lightly.''
Time is running short for AIG. The insurer has "a day" to solve its problems,New York Gov. David Paterson said on CNBC television.
Bankruptcy Poses 'Systemic Risk'
Meanwhile, a company run by former AIG CEO Hank Greenberg said it may try to take over the insurer in a proxy fight or tender offer, according to a regulatory filing on Tuesday.
"It's in our national interest that AIG survive," said Greenberg told CNBC. He said there could be "systemic risks" if AIG's trading partners try to get out of their contracts.
Asked if an AIG bankruptcy were possible, he said if the company doesn't get a bridge loan, new capital, or relief from rating agencies, "then there's no alternative, and that would be a disaster."
Greenberg, who has much of his own personal wealth tied up in AIG, said he has written a letter to the company offering his help, but complained that he has been rebuffed.
Watch Greenberg interview at left.
The former CEO has been at odds with the company since he left in 2005 amid charges of financial misconduct leveled by then-New York Attorney General Eliot Spitzer and the Securities and Exchange Commission. Greenberg denied wrongdoing.
Greenberg's company C.V. Starr said, in a filing with the SEC, that it is working with its adviser, investment bank Parella Weinberg Partners, on strategic options, including buing assets from AIG, taking it private, or trying to buy it in a proxy fight.
In order to take such steps, Greenberg would have to receive approval from the New York Department of Insurance, given strict laws governing those who hold more than 10 percent of an insurer's stock.
A spokesman for New York Insurance Superintendent Eric Dinallo was not immediately available for comment.
Monday's rating downgrades will make it much more difficult for AIG Chief Executive Robert Willumstad to raise cash, and could trigger demands that the company come up with nearly $20 billion.
The insurer has suffered $18 billion of losses in the last three quarters tied to guarantees it wrote on mortgage-linked derivatives. It ended June with $1.05 trillion of assets. Its failure would likely be larger than that of Lehman, which said it ended August with about $600 billion of assets.
Credit Suisse analyst Thomas Gallagher halved his price target on AIG to $3, citing a "heightened probability" of a bankruptcy filing. "While there is a chance the company can work its way through its liquidity problems if it can secure substantial bridge financing, we think this will be challenging to execute in the current onerous credit environment," he wrote.
AIG ended 2007 with 116,000 employees, more than four times as many as Lehman.
Too Big to Fail?
Late Monday, Standard & Poor's cut AIG's long-term credit rating three notches to "A-minus" from "AA-minus," citing "reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses."
Moody's Investors Service on Monday cut AIG's rating two notches to "A2" from "Aa3," while Fitch Ratings cut its rating two notches to "A" from "AA-minus."
The far-reaching influence of AIG in American life. Watch video at left.
S&P told CNBC Tuesday that the key consideration in its ratings changes was the "company's reduced access to the capital markets."
The firm's insurance analyst, Rodney Clark, said AIG has an increasing need to post collateral at a time of diminishng access to capital. And though it is actively pursuing a number of financing options, the situation was "reflecting a lot of risk in its abiity to succeed in putting those solutions in place."
The downgrades mean that AIG's trading partners can require the insurer to post an additional $14.5 billion of collateral, according to an Aug. 6 regulatory filing. They could also result in the early termination of some contracts, requiring an additional $5.4 billion of payments, the filing shows.
"Many people think AIG is too big to fail, but the world will not come to an end if it fails," said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel Inc in Cincinnati.
Despite its problems, AIG has many profitable businesses it could sell, including life insurance, property and casualty insurance, and aircraft leasing. Greenberg estimated the company could raise $20 billion from asset sales if given the time.
On Monday, Paterson said New York would let AIG essentially loan itself $20 billion by shifting liquid investments to itself from some of its regulated insurance units.
AIG's 5.85 percent notes maturing in 2018 fell 11 cents on the dollar to 36 cents, yielding 22.55 percent, the Financial Industry Regulatory Authority bond pricing service Trace said.
Investors on Tuesday were paying $5.2 million up front plus $500,000 annually to protect $10 million of AIG debt against default for five years, up from $3.3 million up front on Monday, according to Phoenix Partners Group.
-Charles Gasparino, On-Air Editor; David Faber, CNBC anchor and reporter; Steve Liesman, senior economics reporter; and Reuters contributed to this report.