(STAR) Wall Street closed higher while Asian and European stock markets made a tentative bounce back yesterday after the US government announced an $85-billion plan to bail out troubled insurance giant American International Group Inc. (AIG).

Stocks initially slumped on the Fed announcement, with the Dow Jones industrial average dropping by about 100 points. However, in late afternoon trading the Dow was up, then closed up about 141 as investors took heart that the central bank did not believe the economy was in as much trouble as many had feared.

All major market indexes finished higher, including Nasdaq and S&P 500.

The bailout, made amid a cataclysmic week for the financial sector, marks a reversal of Washington’s vow not to step in and calls for the US Federal Reserve to lend up to $85 billion to AIG for two years in exchange for a 79.9 percent equity stake.

It came just two days after US authorities refused to rescue investment bank Lehman Brothers Holdings Inc., forcing it into bankruptcy court despite pleas from Wall Street’s chiefs.

AIG’s lifeline bought time for investors to digest an unprecedented run of events that has altered the shape of Wall Street, but did little to ease a funding squeeze caused by the turmoil.

Asian stocks were mostly higher after Tuesday’s dramatic selldown, with Tokyo’s Nikkei index up 1.2 percent and the MSCI Asia-Pacific ex-Japan stocks index up 0.9 percent. Oil rose more than $3 a barrel, and major European markets were expected to open as much as 2.1 percent higher.

“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.”

The Fed stepped in amid worries that a collapse of AIG could cause far-reaching damage to the global financial system, although some market players argued that the government’s move brings just a short-term respite and could do long-term harm.

“What the US 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 US dollars, which long term should be negative to the US dollar,” said Ronald Chan, chief investment offer for Asian equities with Fortis Investments in Hong Kong, where he oversees about $1.5 billion.

“Short-term, I think the systemic risk issue has been reduced on the fact that the Fed is seen to be coming out to save the market, but the recovery is going to be prolonged,” he said.

Around the time the AIG deal was announced, British bank Barclays Plc gave Wall Street another boost: It agreed to buy several parts of Lehman, the Wall Street investment bank that went bankrupt on Monday, for $1.75 billion.

US stocks earlier had clawed back from their largest one-day drop in seven years on speculation about the AIG and Lehman deals. The two largest US investment banks, Goldman Sachs Group Inc and Morgan Stanley, also reported better-than-expected earnings.

The AIG deal overshadowed a Fed decision earlier on Tuesday to hold its benchmark interest rates steady despite market’s counting on an economy-boosting cut in borrowing costs.

Central banks in Japan, Australia and India pumped $33 billion into global money markets as the AIG bailout did little to ease the funding squeeze triggered by Wall Street’s crisis.

Sensitive timing

The rescue keeps AIG from surpassing Lehman as the largest US corporate failure ever. It comes on the heels of a government bailout just over a week ago of mortgage finance companies Fannie Mae and Freddie Mac, and six months after the Fed helped to finance the fire sale of failed investment bank Bear Stearns to JPMorgan Chase & Co.

The move comes at a sensitive time given job losses and tax rates are key issues in the battle for the White House between US Senators John McCain and Barack Obama.

Both candidates struck populist tones in speeches on Tuesday, with Democratic candidate Obama accusing Republican rival McCain of being an opponent of regulation who turned a blind eye to market recklessness. McCain said Obama had taken big donations from mortgage giants Fannie Mae and Freddie Mac.

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.

AIG’s bailout brings to about $900 billion the total of US rescue efforts to stabilize the financial system and housing market. Authorities may get much of that sum back provided asset prices don’t continue to slide.

“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.

Senior Fed staff told Reuters that AIG’s broader business ties and its retail products meant a rescue was necessary, unlike in Lehman’s case.

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.

AIG’s life insurance, property and casualty insurance and aircraft leasing operations are considered healthy. The insurer, founded in Shanghai 89 years ago, employs about 116,000 people and operates in more than 100 countries.

Shares of AIG fell 31 percent to $2.60 in after-hours trade after dropping 79 percent in the prior three trading days.

Critics said that the Fed may have wiped out what credibility it won resisting Lehman’s rescue pleas and may have opened the door to countless other companies to come calling for help.

“We’re essentially continuing a system where profits are privatized and ... losses socialized,” said Nouriel Roubini, a professor at New York University’s Stern School of Business, adding that automakers, airlines and other struggling businesses will be lining up for a government bailout.

Lehman Barclays’ purchase includes Lehman’s North American sales, trading, and research and investment banking businesses, as well as its midtown Manhattan headquarters and two data centers.

About 10,000 of Lehman’s 26,000 employees would join Barclays. Barclays said the purchase requires bankruptcy court approval, and that it can walk away if the deal is not completed by September 24.

In a sign of how much US authorities have been trying to prop up the markets, the Federal Reserve Bank of New York took the unusual step of providing some $87 billion in financing to help underpin trading with Lehman units to prevent disruption as customers fled, court documents showed. – AP

Chief News Editor: Sol Jose Vanzi

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