AIG bailout: Where does financial crisis lead next?

If one harrowing week can take the nation's largest insurance company from blue-chip stock to bailout recipient, how many other titans might fall? When do the financial implosions end?

After a Federal Reserve rescue of AIG Tuesday night, one big crisis was averted. But it's also clear that other companies may follow the insurance giant into a pickle that's increasingly familiar: Exposure to the troubled real estate market and an inability to raise quick cash to cover the resulting losses.

Unlike AIG, which was deemed to be too big to fail, most are unlikely to be rescued.

Already, some other large institutions may be close to the brink. According to news reports Wednesday, federal officials are working to line up a potential private-sector buyer for one of the largest home lenders, Washington Mutual.

In effect, what's going on is a new kind of bank run. It's a run not by depositors – whose money is federally insured in traditional bank accounts – but by investors. And the targets of distrust, while sometimes banks, can be insurance firms, mortgage lenders, or investment broker-dealers.

How many firms will be drawn into the vortex? The answer hinges on how two big forces unwind: falling real estate prices and pressure on financial firms to "deleverage," or make their balance sheets safer.

"There are a lot of credit risks," says George Feiger, chief executive officer of Contango Capital Advisers, an investment advisory firm in Berkeley, Calif. As a nation "we have borrowed more and more broadly than ever before."

On one recent weekend, mortgage giants Fannie Mae and Freddie Mac were taken over by the federal government. On the next, the Fed and Treasury declined to keep Lehman Brothers out of bankruptcy.

It's possible that other big lenders – Wachovia and Washington Mutual are two with stunning share-price drops – "could be material for future weekends," Mr. Feiger says.

If future failures or rescues come, they'd be hard-pressed to outdo AIG in scale, originality, and impact on markets.

Think of it this way: The Federal Reserve and Treasury are in the insurance business. Not just their longstanding business of trying to insure market stability. The actual insurance business.

By extending $85 billion in credit, the Fed wanted something in return, as would any private investor taking such a risk. The government will now have an 80 percent ownership stake in AIG.

AIG writes millions of home, auto, and other insurance policies. Those are considered profitable and safe. And eventually the Fed may be able to sell its stake at a profit.

In the near term, AIG needed an infusion of money to work through problems in its investments in mortgage securities and in credit default swaps (CDS) – contracts that insure others against bond defaults.

AIG was an unusual case in its size and global reach – in the market chaos that would have ensued, analysts say, had it entered bankruptcy.

Even staid money-market mutual funds would have faced losses. This point hit home this week, as the venerable Reserve Primary money fund was unable to maintain its $1 per share price because of exposure to Lehman's bankruptcy.

Since the US taxpayer is its ultimate backstop, the Fed rescue of AIG came with support and involvement of the Treasury. And along with the loan came a new CEO for the company and news that dividend payments could cease to conserve cash.

AIG may have to sell many of its good assets to clean up its balance sheet.

It's a problem that numerous financial firms face, but not all to the same degree.

The investment bank Goldman Sachs is in a strong enough position to say it won't be looking to merge with a large commercial bank. One of Goldman's rivals, Merrill Lynch, just did so.

Bank of America has weathered the credit storms well enough to become Merrill's buyer this week, while rival Citigroup's shares have fallen by about 70 percent in the past year.

That doesn't mean that Citi is headed toward collapse, or that Merrill couldn't have survived on its own. But these are extraordinary times. AIG's current situation seemed unthinkable two weeks ago.

The pace of failures is hard to forecast because it is inextricably tied to the uncertainties in the real estate market as well as to the ties so many firms have to that market.

"[There are] two hallmarks of this credit cycle," says Max Bublitz, chief investment strategist at SCM Advisors in San Francisco. "The first is the incredible amount of leverage," with firms making investments using borrowed money, often at high ratios of 20 or 30 times their underlying capital base.

"Second, the leverage was created around a bubble in housing," he says. Home prices soared far beyond traditional relationships to rental prices or household incomes in many metro areas.

In many cases, firms hold securities based on mortgages that are now seeing rising rates of default and foreclosure. And the risk is that, as firms try to unload their bad assets, the price of those assets will keep falling. Merrill Lynch recently sold one large pool of real estate investments at 22 cents on its original dollar.

A recent commentary on the market by William Gross, a bond fund manager at Pimco, was sobering: "Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium," he wrote. "The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down."

For AIG, the Fed was a new balance sheet. The company's troubles mounted as credit rating firm Standard & Poor's downgraded AIG's debt rating this week.

That meant an instant jump, effectively, in AIG's capital needs. What had been a request for a $40 billion loan last weekend quickly doubled.

In effect, AIG was a "good" company and a "bad" investment firm rolled together. The same was true with Lehman, which hoped to sell or partition its bad real estate investments to survive.

But it could find no buyer. That doesn't mean the real estate investments are worthless, but they're hard to value in the current environment.

Eventually, such assets may recover in value, some Wall Street analysts say. But for now, what matters a lot is their current market value.

When one firm sells assets at low prices, other firms must mark down the value of similar assets on their books, even if they have no need to sell. That's because of "mark to market" accounting rules.

Suddenly, in this manner, balance sheets weaken across the board. Thus, one current debate is whether part of the fix to the downward credit spiral is some revision of mark-to-market accounting.

Another controversial question involves the role in recent collapses played by "short sellers" – investors who make money when stocks fall in price.

Some investors say that they are playing an outsized and unscrupulous part. Feiger is in another camp. "You have a huge amount of short selling," he says. But "most of the times, the market valuations are pretty good guides" to a company's underlying health.