WASHINGTON — In a bid to save financial markets and economy from further turmoil, the U.S. government agreed yesterday to give an $85 billion emergency loan to rescue the huge insurer, AIG.

The Fed's decision came just days after the government refused to bail out investment bank Lehman Brothers. The main difference between the two situations: AIG is so huge and its operations so intertwined in the financial system that the Fed feared an AIG failure could harm the broader economy.

"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 said.

"The President supports the agreement announced this evening by the Federal Reserve," said White House spokesman Tony Fratto. "These steps are taken in the interest of promoting stability in financial markets and limiting damage to the broader economy."

Treasury Secretary Henry Paulson said the administration was working closely with the Fed, the Securities and Exchange Commission and other government regulators to "enhance the stability and orderliness of our financial markets and minimize the disruption to our economy."

"I support the steps taken by the Federal Reserve tonight to assist AIG in continuing to meet its obligations, mitigate broader disruptions and at the same time protect taxpayers," Paulson said in a statement.

The Fed said in return for the loan, the government will receive a 79.9 percent equity stake in AIG and the right to veto the payment of dividends to common and preferred shareholders.

Also, the senior management of AIG will be tossed out, and the government will effectively be in control of the company.

The Fed said the two-year loan was expected to be repaid from the proceeds of the sale of AIG's assets. The company would be put up as collateral.

POTENTIAL LOSSES HUGE

New York-based AIG found itself on the verge of bankruptcy because of mounting losses from investments tied to subprime home mortgages and also from the insurance it was providing to others who invested in mortgages. When credit-rating agencies downgraded the company Monday, AIG suddenly faced a crunch to come up with $14.5 billion to meet its commitments. If the company failed, it could have set off cascading losses across the global financial system.

The possibility of a Fed rescue helped lift the Dow Jones industrial average more than 141 points yesterday, to close at 11,059, recovering part of Monday's dizzying 504-point drop.

AIG's stock, which fell 61 percent Monday, plunged 75 percent more in early trading yesterday but ended the day down 21 percent, or $1.01 a share, to close at $3.75 on trading volume of more than 1.1 billion shares. The fluctuations continued in after-hours trading, with the stock falling as much as 50 percent as uncertainty mounted over the company's fate.

Meanwhile, the two remaining independent investment banking firms — Goldman Sachs and Morgan Stanley — yesterday reported profits that beat analysts' expectations.

Goldman reported a 70 percent drop in third-quarter profit but still earned $845 million, or $1.81 a share. Morgan Stanley's profit fell 3 percent, to $1.43 billion, or $1.32 per share, in the three months ended Aug. 31.

KEY LAWMAKERS BRIEFED

Federal Reserve Chairman Ben Bernanke and Paulson met yesterday with Sen. Christopher Dodd, D-Conn.; Senate Majority Leader Harry Reid, D-Nev.; and House Republican leader John Boehner of Ohio, to brief them on the government's option.

"At the administration's request, I met this evening with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. They expressed the administration's views on the deepening economic turmoil and shared with us their latest proposals regarding AIG," Reid told reporters. "The Treasury and the Fed have promised to provide more details in the near future, which I believe must address the broader, underlying structural issues in the financial markets."

After the congressional briefing, some of those in attendance expressed initial support for the intervention but declined to provide details.

"It's heavy, heavy, heavy. It's much more than has been done except Fannie and Freddie," said Sen. Charles Schumer, D-N.Y., who heads the Joint Economic Committee, referring to mortgage finance giants Fannie Mae and Freddie Mac, which were taken over by the government earlier this month. "But when you look at the alternatives, none of them are better."

CREDIT RATINGS LOWERED

The worries about AIG were triggered after Moody's Investor Service and Standard and Poor's lowered AIG's credit ratings, forcing AIG to seek more money for collateral against its insurance contracts. Without that money, AIG would have defaulted on its obligations and the buyers of its insurance — such as banks and other financial companies — would have found themselves without protection against losses on the debt they hold.

"It might not just bring down other financial institutions in the U.S. It could bring down overseas financial institutions," said Timothy Canova, a professor of international economic law at Chapman University School of Law. "If Lehman Brothers' failure could help trigger AIG's going down, who knows who AIG's failure could trigger next."

AIG operates an insurance and financial services business ranging from property, casualty, auto and life insurance to annuity and investment services. Those traditional insurance operations are considered healthy and the National Association of Insurance Commissioners said "they are solvent and have the capability to pay claims."

AIG had $110 billion in revenue last year and does business in more than 130 countries.

USA Today and the Washington Post contributed to this report.