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The Federal Reserve stepped up to defend troubled insurance giant American International Group (AIG: Summary, Messages, Articles) late Tuesday afternoon, helping the firm avert total collapse and certain bankruptcy. According to early reports, the terms of the deal provide AIG with an $85 billion loan in exchange for an 80% stake in the company.

Fear of failure at AIG, which has been beset by a massive short-term liquidity crunch due to credit default swaps and the rising cost of capital, caused much consternation on Wall Street in recent days. Unlike Lehman Brothers, which was allowed to expire over the weekend, AIG is widely regarded as being too big to fail. With over $1 trillion in assets, AIG has tentacles that penetrate all corners of the international financial matrix.

While AIG common shareholders will likely get short shrift in the deal, index futures are reacting favorably. Taken in conjunction with today’s bold Fed stance on maintaining the Fed funds rate at 2.0%, and the spike in the VIX volatility index over 33 this morning, markets could be poised to bounce hard through the end of the week. Previous spikes in the VIX over 30 have presaged significant market rallies this year.

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