If the $85 bn lifeline the Federal Reserve tossed to American International Group, an extraordinary expansion of its powers, feels ad hoc to you, it should. Because it is.

With the government's rescue of damaged financial behemoths, US taxpayers now own equity in AIG (AIG), Fannie Mae (FNM) and Freddie Mac (FRE). The Federal Reserve is now trying to unload $29 bn in rotten Bear Stearns assets it took on its balance sheet in its orchestrated shotgun wedding between Bear and JPMorgan Chase (JPM).

But the Fed's move should not only make you wonder if AIG is going to get yanked from the Dow Jones Industrial Average list of 30 stocks, and get replaced by Apple, Google--or The Federal Reserve (why is General Motors still in the Dow?)

There remain a host of consequences taxpayers must consider in this rescue.

Who is next on the Fed's watch list. Whether more banks will fail (see below). What happens to the money fund market.

Was the Fed Preparing for an AIG Failure?

The questions also go beyond the fact that, given that AIG can borrow up to $85 bn from the credit facility using its own stock as collateral, the Fed was likely looking beyond Lehman Brothers and preparing itself for AIG's collapse.

That's because, in the past few days the Fed opened the door to let all sorts of collateral be used to borrow at its discount window, including a company's own stock (and that collateral also can now include the mortgage-backed securities Wall Street mints on its own).

Who else sits on its watch list? And with a regulatory meltdown so apparent, we know regulatory loopholes can kill us.

But With the Fed's Move, Do Loopholes Save Us?

First, here's what the Fed did in its AIG bailout, according to its press release:

The Federal Reserve will now "lend up to $85 bn to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers."

The credit facility lasts two years and has an interest rate of three-month LIBOR plus 850 basis points, or a high rate of 11.3%.

The Fed's release adds: "The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance."

The Fed's move buys AIG time to unload assets "with the least possible disruption to the overall economy."

"...The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm's assets."

In return, "the U.S. government will receive a 79.9 % equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders."

The Fed's Siren Call

The government wants to make clear it is not doing a Fannie Mae-Freddie Mac move here, where it is guaranteeing a company's debt.

Instead, the message the Fed wants to send to taxpayers is that it is not guaranteeing anything else at AIG for that matter.

The message loud and clear here is that the Fed wants taxpayers to believe it will profit off the AIG rescue.

AIG gets a two-year loan at a nosebleed interest rate, 11.3%, with a $19 bn interest payment due at the end of its term, as the Fed has exercised, within its purview, a loophole in the law that lets it lend to non-banks in "exigent" circumstances. And with the credit facility comes a nearly 80% equity stake in AIG, now owned by US taxpayers.

AIG is Too Big to Fail

AIG insures cars, homes, skyscrapers, factories, families, other insurers. Its guarantees sit behind mutual funds and money funds, pension funds owned by government workers, 401 (k) holdings, and annuities.  

Despite the Fed's intervention, already a flight out of money funds to US treasurys is underway, driving yields down to record lows, due to the loss of confidence and upon news that the money fund Reserve Primary saw its net asset value drop below $1. The three-month t-bill has plunged to rate levels not seen since 1954, to as low as 0.23%.

AIG's Biggest Minefield for Investors--and Banks

What has become terrifyingly apparent now, AIG is a huge player in the $62 tn credit default swaps market, and a bankruptcy would have ignited massive writedowns around the globe.

Banks around the country have counted these swaps as part of their regulatory capital cushions they are required to hold to support their businesses. If the swaps go down in value, banks could face more writedowns and have to raise more capital, if, in the form of equity raises, diluting existing shares.

CDSs are basically insurance against defaults on derivatives. A swap is essentially debt insurance companies buy on their credit derivatives, whereby AIG would have to pony up money if the assets underlying the derivatives belly flopped.

Swaps are basically AIG's promise that it would make good on any losses to holders of asset-backed bond securities, including mortgage-backed and commercial real estate-backed bonds. With the housing and credit bubble bursting, one estimate of AIG's exposure here reached half a trillion dollars. Caveat emptor: No one really knows the exact dollar amount.

Just look at the swaps swirling around Fannie and Freddie alone.

The Fannie and Freddie Factor

As economist Edward Yardeni points out: "Dealers in the CDS market are now working to settle billions of dollars of such contracts" now amounting to as much as $500 bn on the $1.6 trillion of Fannie and Freddie debt.

Yardeni adds that, "although the debt is regarded as safe after the US government effectively nationalized the two gigantic mortgage companies, their move into ‘conservatorship' counts as the equivalent of a bankruptcy in the credit derivatives market." That remains to be seen.

Yardeni points out that, in the 9/11 edition of the Financial Times, Aline van Duyn, one of the smartest business columnists in the world, reported that the recovery value of the Fannie and Freddie CDS is currently expected to be about 95 cents on the dollar, leading to a potential 5% loss for insurance companies or banks who offered protection against a default.

If their CDS contracts total $200 bn to $500 bn, as some have estimated, the losses would come to $10 bn to $25 bn.

Read Between the Fed's Lines

So note how, as CreditSights, a research firm points out in a special report, the Fed's press statement and dictums governing the AIG rescue do not use the words "default, receivership, conservatorship."

Those words would let counterparties break trades involving AIG credit defaults swaps around the globe. That would create even more writedowns around the world.

As the housing and credit bubble burst, AIG already has seen massive defaults on these derivatives as well as dramatic plunges in values of other securities it owned, triggering more than $40 bn in writedowns and record losses.

How Loopholes Hurt Us

Again, loopholes kill us, but with the Fed's move, do loopholes save us? Loopholes let Enron shove all sorts of bad behavior in off-balance sheet assets, loopholes let Congress set up the biggest off-balance sheet vehicle of all to the US economy, Fannie Mae and Freddie Mac, loopholes let Freddie Mac and Fannie Mae push off their balance sheets some $3.3 tn in hedges.

Loopholes let Citigroup and all sorts of banks squirrel away in off balance sheet structured investment vehicles hundreds of billions of dollars in housing bubble assets.

Loopholes let Congress shove off budget the cost of Social Security and Medicare, now fast approaching $99 tn according to research out of the Dallas Federal Reserve Bank. Ad infinitum, institutionalized juvenilia.

Inflation Comes Barreling Down

And now, presto change-o, section 13(3) "means that the money supply has just been expanded by $85 bn," says David Rosenberg, a top economist at Merrill Lynch. "With this move the Fed and Treasury have blinked in the face of market pressure once again."

Rosenberg adds: "They continue to react to situations rather than getting in front of them and now they have created uncertainty about what firms qualify for bailouts and which do not. Until that goes away, markets will continue to test their limits and that is not good news for markets going forward."

And it spells more inflation, as the government needs to print money to solve these problems, sending the dollar lower.

Yardeni adds: "Bernanke & Co. has slashed Treasury securities held outright by our central bank from $754.6 bn at the end of last year to $479.8 bn now."

He notes: "What did they do with the $274.8 bn in those still-AAA securities? They exchanged them on a term basis with financial institutions stuck with illiquid dodgy securities."

After-the fact refereeing is extremely costly to taxpayers. Is the free market now a regulatory free-for-all too?