American International Group Inc., the largest U.S. insurer by assets, has been given special permission to access $20 billion of capital in its subsidiaries to free up liquidity, New York Governor David Paterson said.

The move buys AIG time to negotiate for a loan from the Federal Reserve, Paterson said today at a New York City press conference. AIG fell 46 percent today in New York trading after a 31 percent slide Sept. 12.

Chief Executive Officer Robert Willumstad is racing to raise cash to forestall credit-rating downgrades on further writedowns tied to derivative contracts backing $57.8 billion in subprime mortgage securities. New York-based AIG may need to raise $20 billion in capital and sell $20 billion of assets, people familiar with the insurer’s plans said. AIG’s prospects dimmed today when Lehman Brothers Holdings Inc. sought bankruptcy protection after failing to find new funds or a buyer.

“AIG has intrinsic value and has options as long as it can get over this immediate liquidity hump,” said David Havens, a UBS AG credit analyst. “It is more important for the government to step in and help AIG than it was with Lehman.”

The insurer will be able to swap illiquid assets to free up holdings at its subsidiaries, Paterson said. “We have seen some of the companies that serve as the bedrock of our financial system unraveling before our eyes,” he said.

AIG dropped $5.54 to $6.60 at 1:38 p.m. in New York Stock Exchange composite trading.

Eric Dinallo

Eric Dinallo, the New York State insurance superintendent, has become the lead regulator charged with finding a solution to AIG’s financial crunch, according to two people familiar with the situation. The people declined to be identified because talks between Dinallo and AIG are confidential.

The Federal Reserve has hired Morgan Stanley to examine alternatives for AIG, a person familiar with the situation said. Morgan Stanley will review what role, if any, the government should play in helping the insurer, said the person, who declined to be identified because the talks are confidential.

Bank of America Corp. Chief Executive Kenneth Lewis said today that AIG’s failure would be a “much bigger problem” than Lehman’s demise.

AIG may report writedowns of $30 billion resulting in its “worst quarter yet” for the period ending Sept. 30 if Lehman’s bankruptcy leads to distressed sales of mortgage assets, providing lower market values for AIG’s holdings, Citigroup Inc. analyst Joshua Shanker said today in a note. He downgraded AIG to “hold” from “buy.”

Credit Ratings

Standard & Poor’s said Sept. 12 it may downgrade AIG’s credit ratings because the share declines may crimp the insurer’s access to capital. The company declined 79 percent this year before today, making it the worst performer in the Dow Jones Industrial Average.

“It seems more and more likely that AIG may go to the Federal Reserve window to borrow cash at the discount rate, should the Fed allow it,” Shanker said.

AIG spokesman Nicholas Ashooh didn’t return calls seeking comment and the Fed’s Michelle Smith declined to comment.

AIG and a group of banks asked for a meeting with the Federal Reserve Bank of New York today to discuss the company’s position, a spokesman for the New York Fed said. New York Fed President Timothy Geithner and Dinallo are leading the meeting that began at 11:30 a.m. U.S. Treasury officials are also at the gathering.

Source: Bloomberg News