Feb. 25 (Bloomberg) -- American International Group Inc. lost about 85 percent of market value since Chief Executive Officer Edward Liddy said five months ago “the mess we’re in is solvable.”

AIG said Sept. 16 it will sell assets to repay an $85 billion loan from the Federal Reserve. Liddy has now concluded that plan won’t work, said two people with knowledge of the matter, who declined to be identified because discussions with the government are private. AIG may hand over stakes in some operations directly to the U.S. to reduce its debt, one of the people said yesterday.

The talks come as AIG, propped up with $150 billion of U.S. aid, prepares to disclose a record fourth-quarter loss of about $60 billion and seeks to fend off credit-rating cuts, the people said. The global financial crisis has slashed the Standard & Poor’s 500 Insurance Index in half since Liddy announced the plan, reducing the prices AIG units can fetch and thinning the pool of companies strong enough to bid for them.

“AIG’s problems have been underestimated by everyone looking at it,” said Marshall Front, who oversees $500 million as CEO of Chicago-based Front Barnett Associates and sold his stake in the company last year. “The exit strategy from here is extremely murky; each time we seem to have temporarily fixed a problem, additional severe problems have emerged.”

One option under discussion at AIG is handing off some of the non-U.S. life insurance businesses to the government in exchange for forgiveness of part of the loans, said one of the people with knowledge of the talks. AIG’s two biggest non-U.S. life insurance units, with major operations in Japan and China, are candidates for those swaps, the person said.

Credit Rating

AIG, once the world’s largest insurer, operates in more than 100 countries and sells life, health and accident protection to individuals and businesses. It insures against some of the biggest risks, covering planes and commercial shipping and providing protection against terrorist attacks.

Company executives remain in negotiations with credit- rating companies and U.S. regulators, and the results of those discussions may be disclosed next week when AIG posts fourth- quarter results, the people said. The insurer may continue to seek buyers for some units as the firm pursues a restructured deal from the government, one of the people said.

The company also is in talks about converting the government’s preferred shares, valued at about $40 billion, to common stock, which would reduce pressure on the company’s cash flow, a person with knowledge of that plan said. The preferred shares pay a 10 percent dividend; the common pay none.

Taxpayer Losses?

AIG climbed 1 cent to 42 cents in New York Stock Exchange composite trading at 9:35 a.m. The company’s stock slumped 99 percent in the past 12 months.

“We continue to work with the Federal Reserve Bank of New York to evaluate potential new alternatives for addressing AIG’s financial challenges,” AIG spokeswoman Christina Pretto said, declining to be more specific. Isaac Baker, a spokesman for the Treasury, declined to comment on AIG.

The government’s loans to AIG won’t result in any loss to taxpayers, Fed Governor Elizabeth Duke said in a Jan. 12 letter. The insurer’s business units are valuable enough to repay debts, Duke said in the letter to Christopher Dodd, chairman of the Senate Banking Committee. Fed spokesman David Skidmore declined to comment yesterday.

Soliciting Bids

Downgrades by Moody’s Investors Service and Standard & Poor’s may force AIG to post more than $7 billion in collateral to counterparties, the insurer said in a November filing. AIG’s units could also lose access to the federal commercial paper program if they are downgraded, the company said. Unprofitable insurers, including Hartford Financial Services Group Inc. and Genworth Financial Inc., have already lost access to the program.

Since Liddy, 63, announced his asset-sale program, AIG disclosed agreements to sell assets for about $2.4 billion, including an equipment insurer and a private bank. AIG had tapped about $38.9 billion of the $60 billion credit line as of Dec. 31.

AIG has been soliciting bids for its American Life Insurance Co. unit and trying to sell a 49 percent stake in American International Assurance Co.

The company received offers from MetLife Inc. and Axa SA for the Alico unit, which does business in more than 50 countries, said three people with knowledge of the situation. New York-based MetLife made a preliminary bid of as much as $11.2 billion, the people said. A rival approach from Axa in Paris excludes operations in Japan, Alico’s biggest market, they said.

U.S. Bailout

The AIA unit has lost appeal among prospective buyers, who appear to have abandoned the bidding process, the Wall Street Journal reported on its Web site, citing people close to the auction. The deadline for offers is Feb. 27, the paper said.

AIG had to seek an $85 billion federal loan in September after credit-rating downgrades left the company facing the possibility of more than $10 billion in collateral calls from debt investors who bought credit-default swaps from the insurer. The bailout, which includes handing the government an 80 percent stake in AIG, expanded to about $150 billion in November, partly to fund an entity designed to retire the swap contracts by purchasing the underlying assets from banks.

The government saved AIG from collapse to prevent losses at banks that did business with the insurer. “Counterparties around the world continue to have significant exposure to AIG, and market conditions continue to be fragile and sensitive to the potential disorderly failure of AIG,” the Fed said in a report published in November.

To contact the reporters on this story: Zachary R. Mider in New York at zmider1@bloomberg.net; Hugh Son in New York at hson1@bloomberg.net

Last Updated: February 25, 2009 09:52 EST