Sept. 15 (Bloomberg) -- American International Group Inc., the largest U.S. insurer by assets, has been given special permission to access $20 billion of capital in its subsidiaries to free up liquidity, New York Governor David Paterson said.

The move buys AIG time to negotiate for loans, Paterson said today at a New York City press conference. AIG fell 61 percent today in New York trading to its lowest level in two decades.

Chief Executive Officer Robert Willumstad is racing to raise cash to forestall credit-rating downgrades on further writedowns tied to derivative contracts backing $57.8 billion in subprime mortgage securities. New York-based AIG may need to raise $20 billion in capital and sell $20 billion of assets, people familiar with the insurer's plans said. AIG's prospects dimmed today when Lehman Brothers Holdings Inc. sought bankruptcy protection after failing to find new funds or a buyer.

``AIG has intrinsic value and has options as long as it can get over this immediate liquidity hump,'' said David Havens, a UBS AG credit analyst.

The insurer ``needs immediate access to capital'' and will be able to swap illiquid assets to free up holdings at its subsidiaries, Paterson said. Each time AIG uses assets as collateral for cash loans, the insurance department will examine the transaction to protect policyholders.

AIG dropped $7.38 to $4.76 at 4:07 p.m. in New York Stock Exchange composite trading. The shares traded for $65.96 a year ago.

`Unraveling Before Our Eyes'

``We have seen some of the companies that serve as the bedrock of our financial system unraveling before our eyes,'' Paterson said.

Goldman Sachs Group Inc. and JPMorgan Chase & Co. are trying to arrange financing for AIG to plug a $70 billion to $75 billion financing gap, according to people familiar with the situation. The Federal Reserve urged AIG to seek private capital and discouraged the insurer from expecting a loan from the central bank, according to two people with knowledge of the discussions.

AIG and a group of banks asked for a meeting with the Federal Reserve Bank of New York today to discuss the company's position, a spokesman for the New York Fed said. New York Fed President Timothy Geithner and State Insurance Superintendent Eric Dinallo were leading the meeting that began at 11:30 a.m. U.S. Treasury officials were also at the gathering.

U.S. Treasury Secretary Henry Paulson said the negotiations involved a ``private sector effort'' and not a loan from the government.

Morgan Stanley

The Federal Reserve has hired Morgan Stanley to examine alternatives for AIG, a person familiar with the situation said. Morgan Stanley will review what role, if any, the government should play in helping the insurer, said the person, who declined to be identified because the talks are confidential.

Bank of America Corp. Chief Executive Kenneth Lewis said today that AIG's failure would be a ``much bigger problem'' than Lehman's demise.

AIG may report writedowns of $30 billion resulting in its ``worst quarter yet'' for the period ending Sept. 30 if Lehman's bankruptcy leads to distressed sales of mortgage assets, providing lower market values for AIG's holdings, Citigroup Inc. analyst Joshua Shanker said today in a note. He downgraded AIG to ``hold'' from ``buy.''

Standard & Poor's said Sept. 12 it may downgrade AIG's credit ratings because the share declines may crimp the insurer's access to capital. The company fell 79 percent this year before today, making it the worst performer in the Dow Jones Industrial Average.

Banking, Aircraft

The insurer is ``working on a number of alternatives,'' said spokesman Nicholas Ashooh, declining to comment further. The Fed's Michelle Smith declined to comment.

The company may consider selling units including American General Finance, AIG's consumer lender, which could fetch more than $6 billion if the unit sold for twice its book value. AIG Investments could sell for more than $3 billion if it sold for 2.5 percent of clients' assets under management. The company's stake in reinsurer Transatlantic Holdings Inc. is worth about $2.25 billion, based on today's share price.

Bank of America analyst Alain Karaoglan said Willumstad, 63, should reconsider the decision to keep its aircraft-leasing unit, International Lease Finance Corp. which could sell for $7 billion to $14 billion.

KKR, J.C. Flowers

AIG rejected investments from buyout firms KKR & Co., TPG Inc. and J.C. Flowers & Co., people familiar with the talks said. Billionaire Warren Buffett's Berkshire Hathaway Inc., is no longer talking with AIG about an investment in the insurer, CNBC reported today, citing unnamed people familiar with the situation.

The insurer raised $20.3 billion in May by selling debt and equity, diluting the holdings of long-time investors. It's ``very hard to predict'' if AIG will need more capital, Willumstad said Aug. 7.

Last week, the U.S. Treasury seized Fannie Mae and Freddie Mac, the two biggest sources of funding for U.S. mortgages, wiping out most of the value of their shares. AIG had $550 million to $600 million of preferred shares in the companies, said a person who declined to be identified because the insurer hadn't made a formal announcement.

Hurricane Ike, which struck Texas Sept. 13, may also pressure AIG, costing insurers $6 billion to $18 billion, the most since the record storm season of 2005, according to firms that specialize in gauging the effects of disasters.

AIG's former CEO and Chairman Maurice ``Hank'' Greenberg, who controls the largest stake in the insurer, wasn't involved in the company's planning Sept. 13 and yesterday and has ``repeatedly offered'' to assist the firm, spokesman Glen Rochkind said yesterday.

Greenberg, 83, saw the holdings decline by $3.1 billion last week. He controls 11 percent of AIG shares through two investment firms and personal holdings.

To contact the reporters on this story: Hugh Son in New York at hson1@bloomberg.net; Andrew Frye in New York at afrye@bloomberg.net.

Last Updated: September 15, 2008 16:56 EDT