The largest insurer in the US was indeed too big to fail.

In an unprecedented move intended to calm frenzied financial markets, the US government assumed control of American International Group (AIG) late last night.

According to the Wall Street Journal, in return for an $85 billion loan to keep AIG solvent, the US government will pick up a 79.9% equity stake in the troubled financial services company. The loan is backed by the assets on AIG’s balance sheet along with its profitable insurance and aircraft leasing businesses. The government seizure is expected to stem fears the insurer would be forced into liquidation.

Such an event would have unleashed chaos in financial markets.

AIG’s massive exposure to the $64 trillion credit default swap market and the implications of its impending collapse proved too much for government officials to stomach.

During the past week, AIG scoured Wall Street for cash - to no avail. An emergency lending facility led by JPMorgan (JPM) and Goldman Sachs (GS) fell apart. Numerous attempts to shed assets failed. Even a short-lived plan to lend itself $20 billion self-destructed.

As recently as yesterday afternoon, reports swirled that a federal bailout was off the table. The company’s stock was punished, falling as low as $1.25 before recovering to close Tuesday at $3.75.


 
At $1.25 per share, AIG's market capitalization was a touch over $3 billion. The price tag of the emergency loan therefore highlights the extent to which this company was levered beyond all rationality.

Late yesterday, Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and New York Fed President Timothy Geithner convened and determined the potentially catastrophic effect of an AIG bankruptcy could not be risked. The bailout is aimed at averting the unraveling of AIG’s massive trading positions - an exercise in financial triage no one wanted try.

In the days since Lehman Brothers’ (LEH) collapse over the weekend, Wall Street has scrambled to determine the true extent of the resulting losses. Countless firms -- many seemingly detached from roiling financial markets -- came forward to acknowledge damage inflicted by the investment bank’s demise.

Constellation Energy (CEG), a Baltimore-based supplier of energy, tumbled nearly 40% yesterday as its ties with Lehman sparked concerns over its liquidity prospects. The company, for its part, denied Lehman’s failure would materially impact its business.

The general consensus was that fallout from the collapse of AIG would make Lehman look like a walk in the park. As Toddo wrote yesterday, “The counter-party risk at AIG makes Lehman Brothers look like a pimple on an elephant’s ass. Something needs to be done and soon.”

The extent to which the landscape of the world’s financial markets has been changed in the past 72 hours is mind-boggling. In the course of a few days, one major investment bank collapsed (Lehman), another hastily sold itself to avoid a similar fate (Merrill Lynch (MER)), and the largest insurance company in the United States was seized by the government (AIG).

And it’s only Wednesday.