Insurer American International Group apparently is too big to fail. The mammoth insurer, which had been pushed to the brink of bankruptcy by problems originating in the US mortgage crisis, is being bailed out by the Federal Reserve.

The Fed will extend a 24-month bridge loan of $85.0 billion to the insurer, in return for an unprecedented acquisition of a 79.9 per cent stake in the firm by the central bank.

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"This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy," the Federal Reserve said in a statement Tuesday night.

Current management, led by CEO Robert Willumstad, will leave, a person briefed on the deal told Forbes.com.

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Shareholders will suffer massive dilution, but their stock has slid from more than $70 last fall to $3.95 Tuesday. The takeover will protect bondholders and counterparties in the world's credit markets as well as holders of AIG insurance policies.

The central bank said it was taking action because of the grave danger posed to the US financial system had American International Group been permitted to go under.

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"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," it said.

AIG, with 103,000 employees and more than $1.0 trillion of assets, is more than an insurance company--if it was unable to honor its obligations it could have set off a cascade of problems around the world.

But the Fed has opened a Pandora's box with its bailout, essentially saying that it is possible for the US government to rescue companies whose executives made bad decisions. The so-called moral hazard issue has been on investors' minds recently, with Washington showing an inconsistent approach.

Lehman Brothers Holdings was allowed to fall into bankruptcy protection, but the Treasury bailed out the former government agencies Fannie Mae and Freddie Mac, and the Fed itself participated in the March rescue of Bear Stearns.

AIG previously found a protector in the State of New York, which agreed to bend rules and allow AIG to borrow $20.0 billion from its operating subsidiaries. That could enable it to obtain some sort of credit facility or additional capital. It will be used to help maintain the company's credit rating. It may also be used as collateral.

New York's governor gave AIG until Wednesday to secure an injection of capital or a credit facility. If it fails to do that, the agreement to let it borrow from its operating subsidiaries is off the table.

The Fed, apparently unable to convince private-sector companies to provide the cash, did the deal itself. That raises the question of whether the financial-services industry really felt that AIG's demise would have been catastrophic. The only alternative explanation would be that Wall Street won a game of chicken with the Fed, forcing it to rescue a private-sector company and setting a precedent that likely will be difficult to live down.

The Fed said that the loan is collateralised by all the assets of AIG and of its primary non-regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm's assets.

Interest will accrue on the outstanding balance of the loan at a rate of three-month Libor plus 850 basis points.