NEW YORK (CNNMoney.com) -- Troubled insurer American International Group got a reworked $152.5 billion deal from the federal government Monday, as the Federal Reserve and Treasury Department made significant changes to the terms of the company's original bailout.

The Fed announced that it will reduce AIG's original $85 billion bridge loan to $60 billion, cut the interest rate by 5.5 percentage points and extend the borrowing period to five years from two years.

In addition, the Treasury will use its special authority under last month's $700 billion bailout law - the so-called Troubled Asset Relief Program - to purchase $40 billion in preferred stock.

The new bailout was worked out between government officials and AIG executives over the weekend. AIG was having difficulty paying back its original bridge loan, which it intended to use to sell off many of its subsidiaries to restore the company to a stable condition.

"This is definitely what AIG needed in the sense that it got rid of the first deal," said Donald Light, senior analyst with Celent. "This one is more tailored to the actual issues affecting the company and has a much better chance of getting AIG the help it needs."

Shares of AIG jumped on the news, finishing the day 8% higher at $2.28 a share. But shares fallen about 90% since the company received its first bailout in mid-September.

The credit crisis has proven to be a difficult environment to spin off assets. Furthermore, the company's investors continued to demand that the insurer post collateral to back its credit default swap agreements - essentially insurance contracts that AIG had sold to customers worldwide - forcing AIG to borrow more and more from the government. As the company drew down billions, the high interest rate on the original loan became too punitive.

"The Treasury determined AIG was a systemically significant institution," a Treasury official said. "Bringing more equity to the company puts AIG in a better position to dispose of its assets, and it was done to protect the taxpayer."

Trying to stop the bleeding

The Fed is also creating two new entities designed to stanch the bleeding in two of the company's divisions that are threatening to topple the insurer.

First, to shore up the insurer's shaky securities lending business, the Federal Reserve of New York will inject $22.5 billion and AIG $1 billion into an entity that will purchase $23.5 billion of residential mortgage-backed securities. This will take the place of a $37.8 billion lending facility made available to AIG last month.

In this division, AIG lent securities to others for a fee and invested the money elsewhere -- much of it in mortgage-backed securities -- hoping for a gain. But it ran into trouble after the mortgage-backed securities declined in value, leaving AIG unable to unwind the loans as the deals expire. AIG said this is the major reason for its recent liquidity issues.

The second entity announced Monday seeks to address the source of the original problems that nearly brought AIG down in mid-September.

Funded with $30 billion from the New York Fed and $5 billion from AIG, it will purchase up to $70 billion of multi-sector collateralized debt obligations, or CDOs, on which AIG's financial products division wrote credit default swaps. As the value of these CDOs plummeted, AIG was forced to post more collateral to back up the swaps. Some 95% of the division's writedowns originate from these multi-sector CDOs.

Once this entity is funded, the credit default swaps on these CDOs will be terminated. This is aimed at stopping the collateral calls that have been overwhelming the insurer.

Analysts speaking on a conference call pressed the company on whether it could convince CDO holders to sell them at 50 cents on the dollar. Executives said the Federal Reserve will drive negotiations and expects them to succeed.

"We cannot continue to hemorrhage cash in posting collateral for credit default swaps," said AIG Chief Executive Edward Liddy. "We need to stop that, and we need to stop that now."

Andrew Barile, an insurance consultant at Andrew Barile Consulting Corp., said the bailout will help ease AIG's need to continue to post more collateral. But he said the company will continue to have trouble selling off its subsidiaries. In the current environment, other smaller companies may rather pluck talent away from AIG than assume its unwanted companies.

"People also underestimate the time it takes to sell off assets of an insurance company, which takes months and months," said Barile.

Also on Monday, AIG reported its biggest quarterly loss ever: $24.5 billion, or $9.05 per share, in the third quarter. Excluding one-time charges, AIG lost $9.2 billion, or $3.42 per share, in the three months ended Sept. 8. That compares to a gain of $1.35 per share during the same period a year earlier.

Liddy attributed the poor results to "extreme dislocations and volatility in the capital markets" during the quarter. Insurance on properties destroyed by Hurricanes Gustav and Ike contributed to $1.4 billion of losses for the company.

The giant insurer, which has more than 100,000 employees worldwide, reported revenue of $11.7 billion, down 0.8% from $11.8 billion in the third quarter of 2007.

But in an encouraging sign, ratings agency Fitch said it removed the company from its so-called credit watch list immediately following AIG's announcement, saying the move is important in promoting global financial stability.

Another turnabout for rescue efforts

The new bailout marks a stunning turn in the Bush administration's efforts to address the escalating financial crisis. It is likely to stoke calls from those advocating federal rescue plans for other troubled companies such as automaker General Motors (GM, Fortune 500), which said Friday it was running dangerously low on cash.

"Clearly there are other industries interested in accessing TARP (Troubled Asset Relief Program) funds, and the Treasury will continue to work on a strategy that will most effectively deploy the remaining funds," a Treasury official said Monday.

Many taxpayers have expressed anger at the government's bailout, saying it rewards risky and unscrupulous behavior of corporations. But Liddy said taxpayers have much to benefit from an equity stake in AIG.

"It is not exactly a bailout, because the American taxpayer will and has been offered considerable returns due to their equity stake in AIG," Liddy said. "This plan is a win-win: When things get better, the government will do well, and AIG will do well."

The Treasury said its $40 billion capital injection into AIG is not part of the $250 billion that was set aside for equity purchase of banks. Rather, the funds came from an additional $100 billion that President Bush requested. The transaction's "one-off" status allowed the government to impose more stringent criteria on executive compensation than on banks receiving Treasury assistance.

As part of the new deal announced Monday, Treasury will limit "golden parachutes" and freeze the size of the annual bonus pool for the top 70 company execs. Most banks participating in the Treasury program face compensation curbs on only their top five executives.

AIG has come under fire from lawmakers and state officials for seeking to make big payouts to former executives and planning pricey corporate events after receiving the federal loans.

In mid-September, AIG (AIG, Fortune 500) teetered on collapse, pressured by the effects of the credit crisis. Worried that the company's failure would domino through the rest of the financial system, the government provided an $85 billion bridge loan. Later, the Fed gave the insurer $37.8 billion line of credit, and made available $20.9 billion in a debt purchasing facility.

Under the new plan, AIG has borrowed the full $40 billion from the Treasury to pay off the $37.8 billion from the Fed. It has drawn down $15.3 billion of the $20.9 billion it can borrow from the Fed's Commercial Paper Funding Facility, and it has already borrowed $21 billion of its reduced $60 billion bridge loan.

The rate on the bridge loan was reduced to 3 percentage points over 3-month Libor from 8.5 points over Libor - currently 5.24%, compared to 10.74%. On the unused portion, AIG now has to pay 0.75% interest, down from 8.5% in the original deal.

"The original bailout was just too onerous for the timing and the cycle," said Barile.

Liddy, who was installed as CEO after the government's September rescue, attempted Monday to quell fears that the company was rapidly losing business. He said that AIG remains "well-capitalized and disciplined in insurance writing," and it continues to hold on to the vast majority of its clients - losing just 10% of its insurance business.

But Barile said given the vast size of AIG, that 10% is a huge amount of lost business, and customers will likely continue to leave AIG when their policies expire.

"With Fortune 500 companies set to renew their insurance policies on Jan. 1, it will be a real test to see small the company can get," he said.

CNNMoney.com senior writer Tami Luhby contributed to this article.