The Federal Reserve said in a statement it determined that a disorderly failure of AIG could hurt the already delicate financial markets and the economy.
It also could "lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," the Fed said.
"The president supports the agreement announced this evening by the Federal Reserve," said White House spokesman Tony Fratto. "These steps are taken in the interest of promoting stability in financial markets and limiting damage to the broader economy."
Treasury Secretary Henry Paulson said the administration was working closely with the Fed, the Securities and Exchange Commission and other government regulators to "enhance the stability and orderliness of our financial markets and minimize the disruption to our economy."
"I support the steps taken by the Federal Reserve tonight to assist AIG in continuing to meet its obligations, mitigate broader disruptions and at the same time protect taxpayers," Paulson said in a statement.
The Fed said in return for the loan, the government will receive a 79.9 percent equity stake in AIG.
Earlier, Fed chairman Bernanke and Paulson met with Senate Banking Committe Chairman Sen. Christopher Dodd, Senate Majority Leader Harry Reid, and House Republican leader John Boehner to brief them on the government's options.
"At the administration's request, I met this evening with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. They expressed the administration's views on the deepening economic turmoil and shared with us their latest proposals regarding AIG," Reid told reporters. "The Treasury and the Fed have promised to provide more details in the near future, which I believe must address the broader, underlying structural issues in the financial markets."
On Tuesday, shares of the insurance company swung violently as rumors of potential deals involving the government or private parties emerged and were dashed. By late Tuesday, its shares had closed down 20 percent - and another 45 percent after hours. Still, no deal emerged.
Sean Egan, president of rating company Egan Jones, would have gone bankrupt if it didn't raise at least $40 billion quickly.
"Trust is so important with these securities that are being handled by the major financial institutions," he told to the new agents. "And that's gone right now."
Michel Lewitt, a money manager at Harsh Capital Management, said the insurance giant could not have been allowed to go under, calling such an event "as serious a situation as this country has faced since the Great Depression."
The problems at AIG stemmed from its insurance of mortgage-backed securities and other risky debt against default. If AIG could not make good on its promise to pay back soured debt, investors feared the consequences would pose a greater threat to the U.S. financial system than this week's collapse of the investment bank Lehman Brothers.
Also on Tuesday, Barclays PLC announced a deal to buy Lehman's North American investment banking and capital markets businesses for $250 million in cash, two days after walking away from a deal to acquire the entire corporation.
The worries about AIG were triggered after Moody's Investor Service and Standard and Poor's lowered the company's credit ratings, forcing AIG to seek more money for collateral against its insurance contracts. Without that money, AIG would have defaulted on its obligations and the buyers of its insurance - such as banks and other financial companies - would have found themselves without protection against losses on the debt they hold.
"It might not just bring down other financial institutions in the U.S. It could bring down overseas financial institutions," said Timothy Canova, a professor of international economic law at Chapman University School of Law. "If Lehman Brother's failure could help trigger AIG's going down, who knows who AIG's failure could trigger next."
New York-based AIG operates insurance and financial services businesses ranging from property, casualty, auto and life insurance to annuity and investment services. Those traditional insurance operations are considered healthy and the National Association of Insurance Commissioners said "they are solvent and have the capability to pay claims."
Despite the fate of AIG looming over investors, Wall Street ended another tumultuous session with a sizable gain Tuesday, partly recovering from its worst sell-off in years after the Federal Reserve said it was keeping interest rates steady.
American International Group Inc., the world's largest insurer, was hit by a wave of downgrades by credit-rating agencies worried that the deteriorating housing market is further undermining the company's battered finances.
All three major agencies - Standard & Poor's, Moody's Investors Services and Fitch Ratings - dropped AIG's ratings at least two notches late Monday. While the new ratings are all still considered investment grade, the downgrades add to the pressure on AIG as it seeks billions of dollars to strengthen its balance sheet.
AIG spokesmen did not return calls seeking comment on the impact of the downgrades. But last month, the company estimated in a regulatory filing that a one-notch downgrade of its long-term senior debt ratings by both S&P and Moody's would force it to post $13.3 billion in extra collateral.
The need for that extra capital would put a constraint on AIG's day-to-day liquidity position, which is why the company has been seeking new financing or capital investments.
Financial stocks across Europe and Asia took a pounding as news of AIG's credit downgrades, along with the collapse of Lehman Brothers, stoked investor fears of wider financial and economic damage.
"My guess is that we haven't seen the bottom," said Tony Dolphin, director of economics and asset allocation at Henderson Global Investors in London.
AIG is in a precarious position, in part, because of concerns about its credit ratings and how that would affect its portfolio of financial instruments known as credit default swaps. The swaps are essentially insurance coverage to protect investors against defaulting bonds or debt.
Moody's said it downgraded AIG "in light of the continuing deterioration in the U.S. housing market and the consequent impact on the group's liquidity and capital position due to its related investment and derivative exposures."
AIG has been battered over the past year by billions of dollars of losses tied to deterioration in the mortgage and credit markets. On Monday its shares fell $7.38, or 60.8 percent, to close at $4.76.
The Federal Reserve has asked Goldman Sachs Group Inc. to work with JPMorgan Chase & Co. about a possible short-term loan to keep AIG in business, according to a person familiar with the request who could not speak publicly because talks were still ongoing. The loan could be for about $70 billion, the person said.
JPMorgan is a financial adviser for AIG. Calls to Goldman Sachs were not immediately returned. Treasury spokeswoman Brookly McLaughlin declined to comment when asked about the possible financing efforts.
New York Gov. David Paterson, meanwhile, stepped to the company's aid by saying the state will allow AIG to use $20 billion of assets held by its subsidiaries to provide cash needed to stay in business.
Paterson asked New York state insurance regulators to essentially allow New York-based AIG to provide a bridge loan to itself. The governor has also asked the head of New York's insurance department to talk with federal regulators about providing an additional bridge loan to AIG.
"AIG still remains financially sound," Paterson said.
The move will allow AIG to use those assets as collateral to borrow cash to fund its day-to-day operations, Paterson explained.
It also helps AIG by "giving them what they need most, which is time," said Keefe Bruyette & Woods analyst Cliff Gallant, who added that the relaxation of insurance regulations is "unprecedented."
Typically, a state insurance commissioner's priority is to protect the policyholder, and that includes making it very difficult for an insurer to access the funds that are used to pay claims.
AIG's chief executive, Robert Willumstad, who has been CEO since June, has indicated he is willing to shed some assets, saying about a month ago that a "less complex AIG would be a better competitor."
Here are five key questions and answers about AIG's current woes and what they mean to you.
I have insurance through AIG. How worried should I be about the problems at the company?
At least in the short term, you probably don't need to be worried at all. The problems are with the AIG holding company, not the individual insurance company subsidiaries that you do business with, according to a source with New York State's insurance regulator.
Even if AIG's holding company is forced to file for bankruptcy court protection, there's a good chance that the subsidiaries will continue to operate normally with no disruption in claims payments. That has happened in the case of other insurance holding companies' bankruptcies in the past, such as Conseco (CNO).
What guarantees that my claims will be paid?
Typically, if an insurance company falls into financial distress and is at risk of having claims that exceed the assets it holds to make those payments, the insurance regulator in its home state will take control of the firm and make payments.
The state regulator will not only use the firm's own assets to make those payments but, if necessary, can also make payments out of a state fund into which all insurers in the state are required to pay.
This guarantee applies not just to traditional insurance policies but also to retirement products that have a promised payout, such as annuities.
But there are limits to the payments that will be made to customers that vary depending on which state a particular AIG subsidiary is based, according to Joseph Belth, professor emeritus of insurance at Indiana University and editor of The Insurance Forum, a newsletter often critical of the industry.
Should I be thinking about changing my policy away from AIG to another insurer?
While credit rating agencies downgraded debt held by AIG (AIG, Fortune 500) on Monday, AIG's ratings are still considered investment grade and the company's insurance subsidiaries are considered to be secure, at least for now.
Belth said changing insurers is not a simple decision.
"A lot depends on what kind of insurance you talk about," he said. "If you're talking about life insurance, you have to think about whether you can qualify with a new insurer, if your health has changed. But it's something you have to consider if the ratings decline into the vulnerable range."
Why should I care about problems at AIG if I'm not a customer?
AIG is by far the world's largest insurer and its stock is found in many mutual funds, including any S&P 500 index fund. It is also a component of the Dow Jones industrial average. All by itself, it's been responsible for dragging the Dow down more than 400 points so far this year.
AIG is also active in the business of credit default swaps, complicated financial instruments used by investors to protect themselves from bond defaults. Lehman Brothers (LEH, Fortune 500) was another major player in that field. If both go away, it would create a tighter credit market for consumers and businesses trying to get loans.
AIG is an insurer, not a lender. Why do I keep hearing about its problems with subprime mortgages?
All insurers take money they collect in premiums and invest them in different forms of assets. The idea is to make money on those investments so that the insurer can keep their premiums low and attract more clients.
But AIG made a bigger investment into securities that were backed by subprime mortgages than most other insurers. As defaults and foreclosures of those loans rose, the value of those securities fell, creating big problems for the firm.
In the past nine months, AIG has reported net losses of more than $18 billion, largely due to its exposure to bad mortgages.
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