In a bid to avoid damaging global economy and avert the worst crisis in the US financial system, the US Federal Reserve stepped in last evening evening to take control of the world's largest insurance company - American International Group, by authorising the Federal Reserve Bank of New York to lend as much as $85 billion.

In an about turn on its previous opposition to bail out the US insurance giant, the US Federal Reserve said in a statement that ''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 loan has terms and conditions intended to protect the interests of the government and US taxpayers, will give AIG the ability to sell certain businesses in an orderly manner, with the least possible disruption to the overall economy,'' it added.

The loan has a two-year term, and will pay an interest rate of three-month Libor plus 850 basis points. Taxpayers are protected, as the loan is collateralised by all of the assets of AIG and its subsidiaries totaling $1 trillion according to its most recent SEC filing.

The bailout forces AIG to give a 79.9-per cent stake to the government which has the right to veto the payment of dividends to common and preferred shareholders.

Edward Liddy, will be appointed as AIG's new CEO and present CEO Robert Willumstad and senior management staff will be asked to leave.

In a statement released by AIG, it said "The AIG Board has approved this transaction based on its determination that this is the best alternative for all of AIG's constituencies, including policyholders, customers, creditors, counterparties, employees and shareholders. AIG is a solid company with over $1 trillion in assets and substantial equity, but it has been recently experiencing serious liquidity issues.

We believe the loan, which is backed by profitable, well-capitalized operating subsidiaries with substantial value, will protect all AIG policyholders, address rating agency concerns and give AIG the time necessary to conduct asset sales on an orderly basis.''

The two-year revolving loan will enable AIG to restructure itself by selling off some of its businesses and repay the loan. The aircraft leasing business and its consumer finance arm may be the first ones to be sold although they may not fetch a good price under the current economic scenario.

According to financial experts the world markets would have been in chaos and the industry could have lost around $180 billion had the government not intervened.

AIG is the biggest commercial insurer in the US and one of the biggest writers of life assurance besides it is the biggest provider of fixed annuities, a popular retirement savings product. Its global operations are vast and reach out to practically all corners of the world.

But the core of its current financial problem stems out from its investment bank where it acted as counterparty in a large number of swap and hedging transactions.

It insured against corporate default on credit default swaps with some protection against losses on collateralised debt obligations. These difficult financial products have suffered large losses because many of them were backed by residential mortgage-backed securities.

AIG lost $18 billion (Rs83,880 crore) over the last few quarters due to its risky transactions in mortgage securities and derivatives. Though it received a $20-billion funding lifeline on Monday where it was allowed to borrow from its subsidiaries, Standard and Poor's rating cuts had created more worries for the New York-based AIG.

The US Federal Reserve and the US Treasury had been asking private sector banks like JP Morgan, Chase & Co and Goldman Sachs Group Inc to bail out AIG but they shied away as AIG needed a whopping $75 billion capital infusion.

Standard & Poor's downgraded certain AIG credit ratings on Monday night forcing the insurer to gamble billions in collateral thus sending it nearer to bankruptcy.