Fearing a possible second major Wall Street bankruptcy this week, the Federal Reserve Board engineered an AIG rescue through a two-year loan that gives the government a stake of 79.9 percent in the conglomerate.

The board determined that a "disorderly failure of AIG" could add to financial market fragility, lead to "substantially higher borrowing costs" and erode household wealth and economic performance, the Federal Reserve said in a statement.

The insurance giant moved to reassure policyholders over the bailout, conceding it had "serious liquidity issues" but said it believed the loan would "protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis."

AIG said it was a "solid company with over $1 trillion (700 billion euros) in assets and substantial equity."

The decision is the latest in a series of interventions by the federal government to stave off collapses in the US finance industry amidst a record rate of home foreclosures that has decimated Wall Street's market for mortgage-backed securities.

Just two weeks ago, the Fed pledged to spend up to $200 billion of taxpayer money to help rescue the government-chartered mortgage giants Fannie Mae and Freddie Mac. Earlier this year, it backed a $29-billion loan for the purchase of troubled investment banking firm, Bear Stearns, by JP Morgan Chase.

Shockwaves reverberate through Europe

European banks were particularly at risk from an AIG bankruptcy by owning three-quarters of the $441 billion in unregulated complex security instruments protected by AIG, the New York Times reported. The securities are tied to the plunging subprime mortgage market.

However, in a statement issued to calm frayed nerves, the head of Germany's central bank insisted the country's financial system could weather the panic that sent shares plunging after US investment giant Lehman Brothers filed for bankruptcy on Monday.

"The German financial system is stable and its resistance to adverse shocks has markedly improved in the past few years," Bundesbank President Axel Weber said, according to the text of a speech released by the bank. "German banks have not indicated any liquidity problems."

A bankruptcy filing by AIG, a huge world player in insuring risk for institutions, would have had an even greater impact on the US and global finance system than by Lehman Brothers' $600-billion bankruptcy, industry experts warned. Had AIG gone into bankruptcy, the financial industry would have faced losses of up to $180 billion, according to RBC Capital Markets.

The Federal Reserve said late Tuesday that it expects the loan to be paid off from cash raised by the sale of AIG assets. They include its consumer lender, American General Finance, a stake in the reinsurer Transatlantic Holdings Inc and an aircraft leasing unit International Lease Finance Corp.

German insurers circling AIG's businesses

German reinsurance giant Munich Re revealed before the Fed's rescue package was announced that it would look at some of AIG's businesses, the head of the German group said.

"Many areas (of AIG) are fundamentally interesting to us," Munich Re head Nikolaus von Bomhard told the daily Handelsblatt, according to excerpts of an interview made available Tuesday.

"The question is to know if they fit with our strategy and if the price is right," von Bomhard said, adding that there had been no talks with AIG.

Munich Re's German rival Allianz also said on Tuesday that it could be interested in parts of AIG if they were to come onto the market but specifically ruled out leasing and reassurance.

The Fed said the move to save AIG was intended to "assist AIG in meeting its obligations" and to help facilitate AIG's liquidation of "its businesses in an orderly manner, with the least possible disruption to the overall economy."

It said the interests of taxpayers were protected because the loan was "collateralized by all the assets of AIG and of its primary non-regulated subsidiaries."

The Federal Reserve stepped in after five days of hard talks with leading Wall Street firms. It had hoped that companies like JP Morgan Chase and Goldman Sachs would put together a private $75-billion deal to float AIG, but the firms said they could not raise the capital, according to the New York Times.

Fed chief Ben Bernanke and Treasury Secretary Henry Paulson met with congressional leaders late Tuesday to explain the bailout, media reports said.

Hours before the deal was announced, the rate-setting central bank voted against loosening monetary policy despite the Lehman Brothers' bankruptcy, AIG's uncertain fate and a 4-percent-plus fall in US stock markets.

AIG a victim of housing crisis and own flawed strategies

As Tuesday dawned, AIG was already tottering after three major US credit rating agencies downgraded its standing. The move devalued the debt securities it had guaranteed to worldwide financial firms and made it more difficult for the struggling insurance giant to raise capital on financial markets to meet its obligations.

At the heart of the problem is the record rate of home foreclosures that have decimated Wall Street's market for mortgage-backed securities. Similarly, AIG got involved in selling so-called credit-default swaps -- unregulated contracts it sold to protect the mortgage-backed securities.

As the debt risk in mortgage securities soared, AIG conceded last month it had sold the swap instruments too cheaply compared to the real risks.

The practices that brought the US financial sector to this woeful state -- repackaging questionable mortgages into enticing investments -- has some analysts questioning whether Wall Street will ever fully recover.

Fed needs to tread carefully, say analysts

The US central bank earlier this year opened up billions of dollars in Treasury-backed securities to investment banks struggling to stay afloat. As collateral, the Fed has accepted the mortgage-related assets that are at the heart of the credit crisis.

On Sunday it broadened the range of damaged securities it will accept in return for loans.

The Fed has to be careful about putting too much of its own reserves on the line, Benn Steil of the Council on Foreign Relations warned on Monday. Too great an exposure to the credit crisis could prompt international investors and governments to pull their own holdings out of the United States, prompting a run on the dollar.