Well, American International Group (NYSE: AIG, Stock Forum) certainly went south faster than we expected. Rather than rising to fill the gap before plunging, it instead plunged straight away. Will there be a bounce? Well, let's look at recent surprise developments before making a prediction.

The U.S. Federal Reserve Board has just agreed to lend up to $85 billion to AIG to allegedly prevent a "disorderly failure" that could wreak economic havoc. The loan is secured by all AIG and primary non-regulated subsidiary assets so that the insurance giant can meet its obligations as they come due.

In return for this massive two-year bridge loan, the U.S. government will receive a 79.9% equity interest in AIG and has the right to veto payment of dividends to common preferred shareholders. Supposedly this will help to stem "already significant levels of financial market fragility" and avoid "substantially higher borrowing costs, reduced household wealth and materially weaker economic performance," according to the Fed. You can see what the market thought of this great idea. Whoa, baby!

Another cover-up for gross incompetence

Never mind that the loan is expected to be repaid from proceeds of the sale of the firm's assets. Since when has the U.S. government suddenly become an investor in private companies? If the risks were too big for private companies to seriously consider, then what business does the government have in risking taxpayer money instead?

And how is it that a company that grew to be the biggest and best insurer, reaped billions of dollars in profits over the past decade, and patted its back over its own cleverness has found itself in such a bad situation that it’s up the creek without a paddle?

AIG has made all kinds of mistakes, so why can't it find a way to survive those mistakes? Surely the government won't be any better at helping to find a solution. After all, here's how wonderfully the government has been managing the money supply over the last several years:

This ever-growing money supply has led to nothing but one asset bubble after another. With artificially low interest rates and a flood of money on tap every time a bank so much as winked at it, the Fed has created a monster of historic proportions.

And remember, our financial institutions wanted our system to work this way. They lobbied the government endlessly and spent an untold amount of money to transform financial legislation to give them the mess that exists today. And now, when it all went inevitably wrong, your tax dollars are being risked to paper over the rapidly spreading cracks and fissures.

How it all happened

In previous years, we had key financial legislation in place for a very good reason and it should have been not only retained but also enforced. Instead the 1999 Gramm-Leach-Bliley Act repealed the 1933 Glass-Steagall Act which eliminated Depression-era walls between banking, investment, and insurance and made this crisis possible.

Glass-Steagall erected walls between banking, investment management, and insurance so that problems in one sector could not spill over into the others, which is precisely what is happening now. Basically, this crisis is a combination of government laxity, government weakness in resisting lobbyists, and greedy (and ultimately incompetent) corporate management who acted like children with loaded weapons once they got what they wanted.

At the moment, the U.S. financial system is like a house of cards with a bit of rubber cement applied here and there. And what's worse is that the current bad situation now includes the government too – not just the market itself. The U.S. government is not only the conservator of mortgage disasters Fannie Mae (NYSE: FNM, Stock Forum) and Freddie Mac (NYSE: FRE, Stock Forum), but this week also finds itself as a lender and owner of inept insurer AIG.

AIG has apparently agreed to start selling parts of itself to pay off the $85 billion loan. But the company hasn't been profitable for many months now and probably won't return to profitability any time soon. Therefore, it has to sell, sell, sell while it can, despite a depleted asset base that has been contaminated with toxic debt.

Not only that, but its credit rating has been slashed (which precipitated the emergency bridge loan), which has skyrocketed its borrowing costs – even before the Fed jumped in with yet another high-interest burden on its operations.

This "rescue" is nothing more than stuffing a damp rag into an already flooding boat in the hope it won't sink quite as quickly – even though there's now extra cargo aboard in the form of added Fed interest payments.

Can AIG bail assets fast enough and repay the taxpayer money it owes? Right now no one knows, but the government decided that your money was worth the risk.

In our opinion, any rise in the stock price to fill the $7.50–$12.50 gap in the chart should be considered an excellent place to go short.

The next victim?

So far, the government has found a buyer offering only indirect help (Bear Sterns), let another bank fail (Lehman Brothers), found a direct buyer (Merrill Lynch (NYSE: MER, Stock Forum)), more or less completely wiped out shareholders’ equity and nationalized two major GSEs (Fannie Mae and Freddie Mac), and become a creditor and shareholder to AIG. Where does it all end?

Already the U.S. Treasury has announced it has created a supplemental funding program to ensure that the Federal Reserve has the cash it needs and the accompanying ability to provide emergency liquidity support for the markets.

In other words, let those money spigots keep on running! Don't fear, the U.S. central bank's balance sheet can't possibly be overstretched now that it’s magically penning more dollars into existence!

Clearly the government is anticipating that more intervention is needed. So who's likely to be next? Rumors indicate that Washington Mutual (NYSE: WM, Stock Forum), the nation's largest savings and loan institution, is next on the fool's parade of fiscal incompetence.

Federal regulators have been calling banks to ask if they would consider buying the company should it eventually falter. Apparently there are worries of a good old-fashioned bank run on $143 billion spread across 42.4 million customer accounts.

So what happens how? Will there be a jump if a favorable buyout happens? Or will it prove impossible to find a buyer in the current environment?

Right now it’s impossible to tell. The entire fiasco is nothing more than a casino with unknown odds, because as one institution falls, the pressure increases on those still standing to suck up the slack and maintain the house of cards. After all, just yesterday the Fed said it wasn’t going to give AIG so much as the time of day, let alone any money. And then suddenly it’s an 80% shareholder!

If it gets bad enough… and enough remaining major players get overstretched, then the Fed will have nobody to put the squeeze on… and then what happens?

We could see an international fire sale of U.S. assets to foreign entities, with the good old U.S. dollar becoming the U.S. peso in the process due to irresistible market forces. Got gold?

Good investing,

Nick Thomas
Analyst, Charts of the Week

Note: The author and publisher do not hold positions in the securities mentioned.