The taxpayer-funded bailout of American International Group (NYSE: AIG) just wasn't rich enough at $123 billion. Oh, and the terms for repayment were just a little bit too tough apparently.

The Wall Street Journal reports (subscription required) that the company has reached a deal with the government to replace that package with a new $150 billion plan. Here's the quick summary: "Under the terms ironed out late Sunday, the government would give AIG more money, including $40 billion from the U.S. Treasury's $700 billion Troubled Asset Relief Program. It would also receive less interest than on the bulk of the original loan, while freeing AIG from exposure to some of the risky financial instruments that nearly caused it to file for bankruptcy protection."

Wow. The government will not be increasing its stake in the company beyond the 79.9% it acquired in the original deal. The original $85 billion, two-year loan will be replaced with a five-year $60 billion loan -- with an interest rate that's 5.5% lower at LIBOR plus 3 instead of LIBOR plus 5.5.

What is difficult for me to understand is why the company's common stock holders are being allowed to retain any interest. Without the government, the company would surely have plunged into bankruptcy now and shareholders would have been wiped out. If saving AIG at the expense of taxpayers is necessary for the health of the financial system, I understand. But why does the bailout have to stuff cash into the pockets of stock market speculators? That's wrong. If the market for the distressed assets we're buying doesn't improve, taxpayers could stand to lose billions of dollars. It just seems obvious that a situation so desperate that it requires the Treasury to speculate on obscure securities shouldn't also provide an opportunity for shareholders to make billions.

The financial crisis is not over. If things were back to normal, banks would be lending to each other and to businesses and individuals. But measures of bank lending risk suggest fear is 12 times as high as it would be in normal times. The reason? Banks know more than you do about what's wrong. And they're not talking about it because they don't want you to withdraw your deposits and sell your stock. What they know is that on October 21st, some of the biggest players on Wall Street could be required to come up with $400 billion that some may not be able to pay.

Last month, the White House decided that we could afford to let Lehman Brothers file for bankruptcy. That proved to be an enormous mistake. It triggered a run on money market funds because one of the oldest such funds, Reserve Primary, broke the buck since it held Lehman Brothers paper. The U.S. responded with a $50 billion guarantee of money market funds. But the biggest consequence of that mistake is in the $54.6 trillion market for Credit Default Swaps (CDSs).

A CDS is like selling insurance on your car to hundreds of people who don't own it -- yet if your car goes up in flames each of those people collects the full value of your car. More specifically, CDSs are insurance against a bond or loan default. Why are CDSs so dangerous? Three reasons: a CDS seller does not need to put any capital aside to cover losses if the security defaults, the buyer doesn't need to own the asset it wants to protect, and there is no central place where information about all these CDS deals is collected and updated.

The banking system has been crumbling for over a year, but last month's collapse of American International Group (NYSE: AIG) -- which prompted an $85 billion government takeover -- suggests that insurance is not immune from the problems. As a reminder, AIG got snared in the $62 trillion Credit Default Swap (CDS) market whose growth was spurred by McCain advisor, Phil "Americans are Whiners" Gramm.

And as insurance crumbles, banks keep suffering. Bank of America (NYSE: BAC) and National City Corp. (NYSE: NCC) are both hurting. How much?

• Bank of America's earnings plunged 68% to $1.18 billion, or $0.15/share -- missing by 60% analysts' forecast of 62 cents. Bank of America will raise capital by selling $10 billion of common stock and slashing its dividend in half from 64 cents to 32 cents. One analyst cut the bank's 2009 earnings estimate to $2.50 per share from $3 per share -- this is well below the $3.12 per share from a Thomson Reuters analyst poll -- and lowered his price target by $2 to $26.

• National City Corp. and its National City Bank both suffered debt downgrades from Fitch. For instance, Fitch slashed the bank subsidiary's long and short-term Issuer Default Ratings (IDR) to A- from A. And it lowered the bank and holding company's Individual rating to C from B.

Some investors/readers -- and certainly casual observers of the stock market in towns small and large -- have been perplexed by the turn of events that has led to the current state of affairs in these United States: namely how and why does the U.S. government need to pass a $700 billion bailout/intervention bill to end a financial crisis in the U.S., possibly globally?

While numerous economic, regulatory, and behavioral factors created the conditions that formed the basis for the crisis, economist Richard Felson told BloggingStocks that the imminent failure of insurance giant American International Group (NYSE: AIG), in his view, "was the flashpoint at which both [U.S. Treasury Secretary Henry] Paulson and [U.S. Federal Reserve Chairman Ben] Bernanke realized that a case-by-case, reactive policy would not be adequate to check the building financial storm."

No AIG, massive exposure

Felson pointed out that at least a portion of hedge fund trades -- and the trades of other financial institutions -- are predicated on the assumption that mortgage-backed securities are good/have value, or, if not, that the insurance behind these securities is in force as a result of policies written by AIG. When it became clear that AIG did not have the assets/resources to pay claims, it was necessary for the U.S. government to take over AIG via a $85 billion loan from the U.S. Federal Reserve for warrants for a 79.9% stake in the company.

The shares of American International Group (NYSE: AIG) soared nearly 23% Monday and are rising fast again today on news that shareholders may band together to prevent the Federal Reserve from snapping up an 80% stake in the insurance firm. Apparently, major investors (which could include Bill Miller of Legg Mason) are hoping that the quick sale of assets will raise enough capital to pay off the Fed's $85 billion loan. However, AIG chief Edward Liddy seemed to put the kibosh on this speculation last night in a CNBC interview.

Liddy told the cable news channel he thinks the government's bailout plan is an "excellent idea," and added that he doesn't consider the Fed's intervention as a step toward nationalization. While the CEO believes that the government's loan will be fully repaid, he noted that a shareholder rescue isn't the most likely outcome. Instead, Liddy plans to prepare a list of assets for sale within seven to ten days, in hopes that the divestments will generate enough cash to stave off the feds at the door.

So, what's for sale at AIG? Well, Liddy made it clear that the firm's Asian operations are both "sacrosanct" and "unassailable." The chief executive also emphasized that he wants his company to emerge on the other side of this crisis as a leaner and more resilient version of itself. "It will look a lot like it did prior to 1998-1999, with less reliance on the financial services side," he told CNBC, noting that AIG will instead focus on its core business of property-casualty insurance.

The State of New York has proposed to start regulating credit default swaps owned by investors trying to protect bonds they own, Bloomberg News reported.

The plan won't apply to credit default swaps purchased by speculators, i.e. swap owners who are trying to profit from an increase/decrease in a borrower's creditworthiness, New York Governor David Paterson told Bloomberg News. Paterson also urged the federal government to follow New York's lead and regulate the rest of the credit default swap market.

Credit default swaps are contracts designed to protect against or speculate on default. CDSs pay the buyer face value if a company fails to adhere to its debt. Hedgers typically use them to guard against bond losses. However, speculators use them as an active investing/trading tool in an attempt to profit from a company's / issuer's credit worthiness.

Economist David H. Wang told BloggingStocks there's an upside and a downside to increased regulation of the $62 trillion CDS market.

"On the one hand, we do need a central regulator in the United States to verify that those selling credit default swaps can in fact pay the swap holder if there is a default claim," Wang said. "The system for swaps was jeopardized when AIG could not pay all claims, and could have resulted in contagion, which prompted the federal government's loan."

Just call it an endorsement of a collective security policy where 'you go first.'

That was how one economist characterized the G-7 group of finance ministers' stance toward the U.S. Treasury Department's proposed $700 billion intervention to stabilize the financial system.

In a conference call statement, the G-7 - - Germany, the United Kingdom, France, Japan, Italy, Canada, along with the U.S. - - said, "We strongly welcome the extraordinary actions taken by the United States to enhance the stability of financial markets and address credit concerns, especially through its plan to implement a program to remove illiquid assets that are destabilizing financial institutions," The Wall Street Journal reported Monday(subscription required.)

However, none of the other six G-7 members will adopt a program similar to the U.S.'s, German Finance Minister Peer Steinbrueck told reporters in Berlin after the call, Bloomberg News reported Monday.

Economist Peter Dawson told BloggingStocks Monday the G-7's stance is half-hearted, in his interpretation. "In its general statement, the G-7 is on-board with the [U.S] Treasury's program but [German Finance Minister Peer] Steinbrueck's comments are disappointing. Steinbrueck, or another G-7 representative should have followed up with 'and we stand ready to assist the United States and other nations with fiscal measures to support the above goals, if needed, etc.,' " Dawson said. "Right now, the G-7's tone is 'go forth U.S., but we're not getting in the pool right now, the water's too cold.' Given the G-7's complicity in causing the problem and their systemic interest, a more-engaged statement should have been issued regarding fiscal policy options."

Cites AIG's 'interconnectedness'

For example, Dawson said the G-7's corporate involvement in American International Group's (NYSE: AIG) is evidence item 'A' for stronger G-7 involvement. "G-7 companies, banks, and institutional investors benefited from AIG's credit default swaps and related products, and would be hurt by a systemic failure. Since they are parties to the problem, they should also bear some of the costs of the reforms and bailout," Dawson said. "But right now their stance is 'Go ahead U.S. We back your spending your money, but not ours.' That's an inadequate response from our G-7 associates."

Historians are likely to look back on this week as one of the most significant in American economic history. This was the week that the government let Lehman Brothers Holdings Inc. (NYSE: LEH) fail -- a record $639 billion bankruptcy, lent $85 billion to keep American International Group (NYSE: AIG) from collapsing, and pumped $300 billion into global financial markets to keep them from seizing up. But that turned out not to be enough to keep the markets afloat -- for that Hank Paulson needed the ultimate bailout.

While I don't remember much of the American History I studied in high school, one thing sticks with me today. It always seems that it takes a major crisis to get America to make big changes. It is never possible for leaders to foresee problems and take action to avert them before they turn catastrophic. The averting catastrophe approach always struck me as far smarter than the crisis approach. However, it seems that lawmakers need tangible evidence of prior bad outcomes to make the case that the status quo is deeply flawed and must change.

While he had already loosened up $800 billion in taxpayer money by Wednesday, Paulson needed an even scarier story to get Washington to agree to an additional $500 billion to create an agency to buy illiquid assets from financial institutions. What exactly did he tell Congress and the president to scare them into agreeing to this plan? AP suggests that he described evidence of the global financial market ceasing to function and painted a frightening picture of the economic and political chaos that would ensue if that functioning ceased for an extended period of time.

The New York Times reports that the Federal Reserve has less reserves. Specifically, a year ago it had $800 billion in reserves and that number is down 63% to $300 billion. The other $500 billion is "encumbered" -- that's a nice way of saying that instead of being invested in "safe" Treasury bills, the Fed owns the assets of American International Group (NYSE: AIG), $29 billion worth of grubby former Bear Stearns collateralized debt obligations (CDOs) and the like through a little something it calls "Maiden Lane LLC", and tens of billions worth of the same from Lehman Brothers Holdings Inc. (NYSE: LEH) and other banks.

I raised the question of Fed solvency in July. Whether it was solvent then, it is less so now. But is there a limit to how much money the Fed can create to fund itself? With demand for Treasury Bills skyrocketing (albeit at interest rock bottom interest rates of 0.14% for the 1-month bill), it looks like now would be a great time for the Fed to replenish its coffers by issuing a trillion dollars worth to shore up its balance sheet. If it can indeed do that, the downside is that these low rates will pay it very little income.

And assuming that the Fed does not want to be in the business of owning half a trillion worth of encumbered assets, it will eventually need to get rid of them. And in so doing, it could find itself in competition with the ever- dwindling portion of the investment banking and insurance industry which the government does not own. How so? Because the Fed will be competing to get the best price for the assets it is trying to sell.

Will it use its power to put those publicly traded companies in a pickle? Or will it forgo the advantage to the taxpayer so its competitors can profit? Beats me.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns AIG shares and has no financial interest in the other securities mentioned.

As of midday Monday, the Dow had rebounded off early-session lows, but if investors / readers are thinking about entering this market now, caution is advised, for several reasons.

First, those familiar with technical analysis know that the Dow's rebound to a loss of 180 points to a level of about 11,233, up from a loss of more than 300 points, could be just short-covering.

Second, major unknowns exist regarding the financial system. And I mean major.

The fate of American Interational Group (NYSE: AIG) remains an enormous question mark. The largest insurer of assets, AIG may face a downgrade that would trigger a collateral call from debt investors who bought credit default swaps, a form of insurance for bonds. Further, if hedge and other institutional investors sense those swaps are not in force, they may seek swaps elsewhere and/or sell assets to reduce market risk / raise capital. That could spark a new round of stock selling. AIG's shares fell $5.33 to $6.81 in late Monday morning trading.

The dollar Monday recovered from lows registered earlier in the session, but traders said uncertainty permeated the currency market, given the unprecedented developments in the global financial system.

"We're in unchartered waters, and no one is certain about the impact on the dollar or the financial system," currency trader Andrew Resnick told BloggingStocks earlier Monday. "The logical, rational view is that the dollar will fall based on the expectation of increased government spending and borrowing to deal with the widening financial crisis. But a major dollar fall may not occur if the markets judge the worst is over. That's why a lot of traders are flat now." Resnick added that he was flat, or had no open currency trading positions.

The dollar initially fell early Monday morning about 1.5-2% against the euro, British pound, yen and Swiss franc, but recovered somewhat after the European Central Bank and the Bank of England joined the U.S. Federal Reserve in taking action to calm the financial markets jolted by Lehman Brothers (NYSE: LEH) bankruptcy filing, Bloomberg News reported Monday.

ECB, BOE, Fed all add liquidity to system

The ECB awarded banks a one-day, money market auction of $30 billion that was three times oversubscribed, while the BOE loaned banks $9 billion for three days. Earlier, the Fed expanded the collateral it will accept for loans to securities firms.

The global financial system teeters on the edge of a collapse the likes of which has not been seen in at least 80 years. Thanks to the complexity of the financial instruments involved, the amount of leverage used to trade them, and the global interconnectedness of it all, it could be the worst collapse in financial history. The key question at this point is "What will make it stop?"

The latest news features a bankruptcy of a 158-year-old financial firm, the acquisition of one of the most storied names on Wall Street, and a major restructuring of one of the world's largest insurance companies. Here are the details:

• As I predicted this morning, Lehman Brothers Holdings Inc. (NYSE: LEH) is expected to file for bankruptcy tonight, according to Bloomberg News. That outcome was far from certain this morning as Bank of America (NYSE: BAC) was expected to bid for the "good" part of Lehman. But the US declined to backstop Lehman's bad part so Bank of America withdrew its offer and now Lehman shareholders will be wiped out. It is not clear how severely the Lehman bankruptcy will hurt global markets.
• The good news, as I posted this afternoon, is that Bank of America has agreed to pay $29 a share for Merrill Lynch & Co., Inc. (NYSE: MER) according to the Wall Street Journal. This is great news because it gives Merrill shareholders a $12 a share premium and takes out what would have been the next firm to fail. I am not sure how Bank of America will make the deal pay off, but now attention focuses on the next domino to fall.

MAJOR PAPERS:

• The Wall Street Journal's "The Game" column speculates that one of the results of the Bear Stearns crash could be the push of investment banks and commercial ones closer together, which could result in better handling of volatility with more stability. Some observers think Merrill Lynch & Co (NYSE: MER), Morgan Stanley (NYSE: MS) or The Goldman Sachs Group Inc (NYSE: GS) could go that route by buying a commercial bank. Any move would force them to adhere to better reserve ratios, affect short term bank funding, and shrink balance sheets.
• The Wall Street Journal reported that Google Inc (NASDAQ: GOOG) will soon make available a new service that measure hits on the Internet with the intent of helping advertisers decide where to buy ads online and would directly compete with comScore Inc (NASDAQ: SCOR) and Nielsen Online. Ad executives said Google's method could make targeting markets more efficient.
• A Manhattan judge dismissed four claims made by American International Group Inc (NYSE: AIG) in its fight to regain control of a block of its shares held by Starr International, a company that once founded a lucrative compensation plan for AIG executives. AIG believes the shares held by Starr should continue to be used to fund employee compensation, the Financial Times reported.

WEB SITES:

• According to Scorpio Partnership, Bloomberg reported that UBS AG (NYSE: UBS) and Merrill Lynch had slower growth in assets under management last year due to losses connected to the U.S. subprime crisis.

American International Group (NYSE: AIG) shares are trading higher today after Citigroup upgraded the stock to "Buy" from "Hold," adding in a note that AIG is poised for well over 35% upside within the following year. If you think that the stock won't fall by too much in the coming months, then now could be a good time to look at a bullish hedged trade on AIG.

After hitting a one-year high of $72.75 last June, the stock hit a one-year low of $31.05 yesterday. AIG opened this morning at $32.38. So far today the stock has hit a low of $31.97 and a high of $32.52. As of 12:00, AIG is trading at $32.37, up 0.85 (2.7%). The chart for AIG looks bearish and steady, while S&P gives the stock a neutral 3 STARS (out of 5) hold rating.

For a bullish hedged play on this stock, I would consider a July bull-put credit spread below the $25 range. A bull-put credit spread is an options position that combines the purchase and sale of put options to hedge risk in case the stock doesn't do what you think but still leverage nice returns. For this particular trade, we will make a 4.2% return in just four weeks as long as AIG is above $25 at July expiration. AIG would have to fall by more than 23% before we would start to lose money.

AIG hasn't been below $31 at all in the past year but has broken below support levels recently. This trade could be risky if the financial markets continue to nose-dive, but even if that happens, this position could be protected by the fact that its next earnings are not scheduled until August, which is after expiration of the trade above.

Brent Archer is an options analyst and writer at Investors Observer. At publication time, Brent neither owns nor controls positions in AIG.

MAJOR PAPERS:

• Investors are taking their money out of hedge funds more now that at any time over the past 10 years, according to the Wall Street Journal. Firms are bracing for the end of June when the next big wave will hit.
• First it was a demand for management changes, and now shareholders, including one time director Eli Broad and fund managers Shelby Davis of Davis Selected Advisors and Bill Miller of Legg Mason Inc (NYSE: LM), are again upset with American International Group Inc (NYSE: AIG) and want changes in the boardroom as well, the Wall Street Journal reported.
• The Wall Street Journal reported that Citigroup Incorporated (NYSE: C) will close Old Lane Partners, a hedge fund co-founded by CEO Vikram Pandit.

OTHER PAPERS:

• Spotlight Capital is increasing pressure on Chico's FAS Inc (NYSE: CHS) and said it has been in touch with 25 major shareholders in order to oust CEO Scott Edmonds and unseat board member John Burden, who are accused of having a conflict of interest, the New York Post reported.

WEB SITES:

• Advanced Micro Devices Inc (NYSE: AMD) denied reports certain of its new dual-core chip, code-named Kuma, have been canceled, according to CNet. A spokesman for the company said that the launch of Kuma, scheduled for the second half of 2008, remains on track.