NEW
YORK - The Federal Reserve is close to a deal to take an 80 percent
stake in American International Group in exchange for an $85 billion
loan, according to sources familiar with the negotiations.

AIG’s failure could open the ugliest chapter yet of the financial meltdown.

“The
glimmer of hope has turned into a ray of hope,” said the person, who
asked not to be named because of the sensitive nature of the talks to
help AIG.

Treasury Secretary Henry Paulson and Federal
Reserve Chairman Ben Bernanke met with members of Congress to brief
them on options the government is considering. The meeting ended
without Bernanke and Paulson commenting.

Hoping
to stave off what would be the ugliest chapter of the financial
meltdown, AIG executives huddled with Fed officials and representatives
from top banks at the New York Fed in downtown Manhattan to find the
cash the huge insurer needs to stay in business.

One
solution: A plan to have the government provide financial backing to
ensure that AIG could secure a short-term loan from banks worth up to
$100 billion to stay out of bankruptcy court, the person, who had
direct knowledge of the talks, said.

He
said the discussions had stalled because AIG did not have enough
collateral to obtain a loan of that size. Both sides were trying to
figure out how to close the gap between the amount AIG needs and the
amount of collateral it has.

The person said it was increasingly likely the Fed would step in with taxpayer money.

Shareholders
would be severely diluted by the bailout, which involves a bridge loan,
according to sources. The government would receive warrants for most of
AIG's equity in the bailout being negotiated. CNBC said the deal would
give AIG incentive to sell its assets quickly to help pay off the
bridge loan.

“This
would mean another shareholder wipeout,” said David Ader, head of
government bond strategy at RBS Greenwich Capital in Greenwich, Conn.

Just
days ago, Paulson said the government would not help Lehman Bros. with
the kind of taxpayer-backed funding that JPMorgan Chase & Co.
received six months ago to buy ailing Bear Stearns.

Lehman, the nation’s fourth-largest investment banker, filed for bankruptcy Monday.

“They’re
too big to fail. AIG touches too many people and too many companies
globally, and it would be much more of a disorderly event if it went
bankrupt than it was with Lehman,” said Anton Schutz, president of
Mendon Capital in Rochester, New York.

AIG shares closed Tuesday at $3.75 a share, compared with a peak of $70.13 during the past year.

Earlier,
New York Governor David Paterson told CNBC that the insurer had “a day”
to solve its problems. A failure would result in a “catastrophic
problem” for the market, said Paterson, whose administration oversees
regulation of AIG.

New York-based AIG operates a range of
insurance and financial services businesses ranging from property,
casualty, auto and life insurance to annuity and investment services.
Those operations are considered healthy and policyholders would likely
be covered even if AIG were to file for bankruptcy protection, said
Donald Light, a senior analyst with Celent.

The
problems at AIG stem from the more exotic financial products it offers,
including some that insure risky debt and bonds against default. The
value of those products have deteriorated amid the downturn in the
credit markets over the past year.

If
AIG were to file for bankruptcy, billions of dollars of insurance
contracts known as credit default swaps would likely be wiped out. Much
of those losses would be absorbed by the companies holding the
contracts, which were sold by AIG.

For the three quarters ended in June, AIG itself has lost about $25 billion in the value of its credit default swaps portfolio.