Banks frantically seeking dollar funds have been stonewalled by others increasingly reluctant to lend amid uncertainty and nervousness following the collapse of Lehman Brothers and the bailout of AIG.
The U.S. Securities and Exchange issued new rules governing the conduct of people who profit from stock declines as shares of major financial institutions plummeted on fears of a global credit crunch.
Ripple effects of the credit crisis. See video at left.
The three SEC rules cover shares of all publicly traded companies and follow a brief emergency rule this summer that was aimed at curbing illegal short selling in 19 major financial stocks.
The AIG rescue came just two days after U.S. authorities refused to rescue investment bank Lehman Brothers. The Fed stepped in amid worries that a collapse of AIG could cause far-reaching damage to the global financial system.
"Thank God," exclaimed Daniel Fuss, an influential bond manager who oversees more than $100 billion at Loomis, Sayles & Co in Boston. "AIG is interwoven with so many people and touches many companies around the world. This is a huge relief to many parts of the financial markets."
But others worried that the rescue of AIG brings short-term relief but may lead to other problems down the road.
"What the U.S. government is doing is basically delaying the recovery of the economy really by keeping AIG alive and by going back to the printing press to issue more U.S. dollars, which long term should be negative to the U.S. dollar," said Ronald Chan, chief investment offer for Asian equities with Fortis Investments in Hong Kong.
AIG's lifeline bought time for investors to confront unprecedented financial turbulence that has altered the shape of Wall Street, but did little to ease a funding squeeze. The cost of borrowing rose sharply, indicating a deep lack of trust among banks after Lehman Brothers filed for bankruptcy protection.
The rescue of AIG, whose failure would have been larger than Lehman, comes on the heels of a government bailout just over a week ago of mortgage finance companies Fannie Mae and Freddie Mac. It also comes six months after the Fed helped to finance the fire sale of failed investment bank Bear Stearns to JPMorgan Chase.
The move comes at a sensitive time given job losses and tax rates are key issues in the battle for the White House between U.S. Senators John McCain and Barack Obama.
AIG will pay interest at a steep 8.5 percentage points above the three-month London Interbank Offered Rate, equal to about 11.4 percent.
That gives AIG a big incentive to embark on a massive asset sale program to pay back the loan quickly.
"In current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," the Fed said in a statement.
AIG faced a cash crunch after $18 billion of losses over three quarters, largely because of complex securities that are tied to mortgages, and which plunged in value as the nation's housing crisis deepened.
Investors and credit rating agencies grew more doubtful that AIG could offset its losses with enough capital, which became prohibitively costly to raise as its share price plunged.
—Reuters contributed to this report.