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The talks are at a sensitive stage and it is not a done deal, with terms still being worked out, the source said. An announcement could be made as soon as this weekend or on Monday, when AIG is due to report its quarterly results.
The government extended AIG, once the world's largest insurer, $85 billion in bailout financing in September, and later raised the loan to $123 billion.
The initial credit line has a two-year term, carrying a steep interest rate. AIG also had to grant the government warrants for a nearly 80 percent stake in the company.
As of Nov. 5, the insurer owed $81.2 billion -- $61.3 billion under the $85 billion credit facility, and $19.9 billion under a subsequent $37.8 billion securities lending agreement.
The terms being discussed include a reduction in the interest rate and increasing the term of the existing loan, which could be extended to five years, the source said. Currently the loan carries an interest rate of 8.5 percent over the London Interbank Offered Rate, which sets the cost of borrowing between banks.
An equity injection through preferred shares may also come with a reduction in the size of the $85 billion facility, the source said.
The talks with the government also include the possibility of setting up vehicles to reduce cash drain on AIG associated with credit default swaps and securities lending, the source said.
Among the options being discussed is a plan to set up a facility where the government would buy residential mortgage-backed securities from AIG's securities lending portfolio.
The size of the facility is unclear and the final figure could change substantially, but in talks earlier this week the size being considered was $20 billion to $25 billion, the source said. Such a facility would wipe out the one for $37.8 billion created in October, the source said.
Under the other vehicle, the government would buy some of the bonds underlying credit default swaps, a type of insurance contract providing the buyer with protection against risk. Such a facility would be offset by the cash collateral of about $30 billion that AIG has posted to back those CDS and that the government can expect to get back, the source said.
The size of such a facility is also under discussion and could again change substantially, but in talks earlier this week it was seen to be in the range of $60 billion to $70 billion, the source said.
"This is really just the portion of the credit default swap book that has caused like 90 percent of the writedowns," the source said. "They will only take out the bad stuff."
AIG spokesman Joe Norton said, "AIG continues to work on its plan to find a permanent solution to its liquidity losses, sell assets so it can repay the Federal Reserve Loan with interest, and explore other avenues to help AIG restore its financial health."
(Additional reporting by Lilla Zuill; editing by John Wallace)
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