After numerous mind-wrecking sessions over a fortnight, on Thursday, American International Group Inc. (AIG) and the U.S. Federal Reserve have finally charted out a scheme to free the company from the exorbitant debt that AIG had take under the Troubled Asset Repurchase Program (TARP). Evaluation also came in from the credit rating agency, A.M. Best, who affirmed its issuer credit rating of “bbb” on AIG, reflecting a negative outlook.

According to the proposed plan, the U.S. Federal Reserve has agreed to divert AIG’s TARP loan obligations towards the U.S. Treasury. In turn, the Treasury will convert $49.1 billion of preferred shares held with the government to about 1.7 billion shares of AIG’s common stock, at a discount to Wednesday’s closing price of $37.45.

However, the Treasury is still expected to hold about 92% of AIG’s common stock, the complete offload of which is not expected before the first quarter of 2011, after converting its preferred interests. This holding will be sold over time depending on the performance of AIG’s shares in the market. The proceeds from the AIG’s ALICO sale and AIA IPO will be utilized to repay the line of credit extended to AIG by the FRBNY credit facility before the end of the first quarter of 2011.

On the one hand, the government authorities are still mulling over the profitability of the agreement. It is believed that if the shares of AIG continue to trade equal or higher than the current levels, only then there’s scope of a gain since the warrants of AIG carry a strike price of $30 per share. On the other hand, it is a crucial, faster but riskier step for AIG since the company has already used most of the other sources such as asset disposals to accumulate funds.

Further, though AIG management desired to hold on until November 2010 at least, it sooner realized that the plan could not only hasten the debt reduction process but also help in the ongoing initial public offering (IPO) of its Asian wing, AIA Group Ltd. (AIA). Also, AIG will soon be better able to access the debt markets once the plan is executed.

It appears that AIG is giving in to this plan so that it can now focus on its core property and casualty and domestic life insurance businesses, after disposing off more than 30 assets, divesting a U.S. auto insurer, more than 50 aircraft from its plane-leasing unit and Israeli and Canadian mortgage guarantors, among other major ones.

While the AIA is scheduled for listing in the Hong Kong exchange, AIG expects to raise about $15 billion from the IPO. Meanwhile, AIG has also vended off its American life insurance unit, ALICO to MetLife Inc. (MET) for $15.5 billion (deal to be closed in November this year) and yesterday the debt-driven company agreed to sell off its two Japanese life assurance subsidiaries, AIG Star Life Insurance Co. and AIG Edison Insurance Co., to U.S.-based insurance group, Prudential Financial Inc. (PRU), for $4.8 billion.

While acquiring two well-known insurance entities in Japan and merging them with a couple of its own Japanese life assurance wings will certainly add to Prudential’s competitive strength to stand against its domestic opponents, the deal will make a good share in the de-leveraging process of AIG.

Overall, the decision to convert the various ownership interests of the U.S. government to common stock, which will ultimately be sold to public investors, appears to be an essential step to be taken for the stabilization of AIG. The company is the only insurer left to repay its TARP loan, whereas Hartford Financial Services Group Inc. (HIG) and Lincoln National Corp. (LNC) have already repaid their bailouts and the Treasury raised more than $900 million by selling warrants in the companies.

Although these actions will result in streamlining AIG’s operations and the debt reduction will strengthen its balance sheet, the company’s ratings lay exposed to the risk of been heavily dependent on the U.S. government’s support, which also includes the availability of significant liquidity.

Going forward, we believe that AIG will now have to stand on its own feet once again, while maintaining ample liquidity and re-establish itself in the industry. This is also important to restore shareholder confidence.
 
AMER INTL GRP (AIG): Free Stock Analysis Report
 
HARTFORD FIN SV (HIG): Free Stock Analysis Report
 
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PRUDENTIAL FINL (PRU): Free Stock Analysis Report
 
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