The US Treasury is to sell $40 billion worth of bonds to help the Federal Reserve as it battles to shore up the country's economy and financial system.

The announcement came on the heels of the Federal Reserve's decision late on Tuesday to provide insurer American International Group (AIG) with an $85 billion loan in return for a 79.9% stake in the company.

In a statement the treasury said it was launching 'a temporary supplementary financing programme' at the request of the Fed. The Fed has announced a series of spectacular moves to help the country's economy, including bailing out AIG.

Last weekend, the US government took over mortgage finance companies Fannie May and Freddie Mac, and in March it helped salvage investment bank Bear Stearns. On Tuesday it injected $70 billion of liquidity into the US economy to help stressed financial markets, to keep credit flowing for banks amid the credit squeeze.

Meanwhile, the White House has defended actions taken to rescue troubled AIG, saying it prevented broader harm to the economy. It added that there was concern about other companies.

Treasury and Federal Reserve chiefs and other government economic advisors had determined 'some of these companies were so big that to allow them to fail would have caused even greater harm and damage to the economy,' White House spokeswoman Dana Perino said.

She said the administration was continuing to work with other companies to see if any other losses could be stemmed, though she did not name them.

The rescue of AIG came as it appeared to be in a death spiral after more than a week of panic and turmoil in financial markets that led to the failure of investment giant Lehman Brothers and a sale of Wall Street rival Merrill Lynch.

Treasury Secretary Henry Paulson said he approved the deal, saying it would 'mitigate broader disruptions and at the same time protect the taxpayers'.

Some analysts had argued that an AIG collapse could trigger a wave of failures in the global financial system and deepen the credit crunch.

In a statement issued before news of the rescue, AIG said its insurance, retirement and other financial services were operating normally.

AIG said its businesses, 'including its extensive Asian operations, continue to operate normally and remain adequately capitalised and fully capable of meeting their obligations to policyholders.'

Far more than other insurers, AIG has been a big player in a complex parallel market called credit default swaps (CDS), financial instruments in which Wall Street companies take out a form of market insurance against the risks of bond default.

These products, often linked to the US property market, are at the heart of the current banking crisis and have led to massive write-downs of assets around the world.