The near-collapse of the systemically important American International Group, Inc. (AIG) highlights broad failures of the U.S. financial system, Treasury Secretary Timothy Geithner said Tuesday.

In addition, he called the $165 million in bonus payments amid an unprecedented influx of taxpayer dollars deeply troubling and outlined the Treasury's efforts to recoup the bonuses. As of Monday, $30 million of the $165 million had been returned.

Testifying before the House Financial Services Committee along with Federal Reserve Chairman Ben Bernanke and New York Federal Reserve Bank President William Dudley, Geithner pledged to work on improving the regulatory structure in order to prevent another situation.

I share the anger and frustration of the American people, not just about the compensation practices at AIG and in other parts of our financial system, but that our system permitted a scale of risk-taking that has caused grave damage to the fortunes of all Americans, Geithner said in prepared testimony.

He admitted that he first became fully aware of the bonuses on March 10th, finding the compensation payments deeply troubling.

Consulting with AIG CEO Edward Liddy upon learning of the payments, Geithner realized that demanding repayment risked doubling or tripling the amount paid to the employees.

Liddy explained that the contracts for the retention payments were legally binding and pointed out the risk that, by breaching the contracts, some employees might have a claim under Connecticut law to double payment of the contracted amounts, Geithner explained.

Much of the public anger has fallen upon Mr. Liddy, but this is not fair, Geithner told lawmakers.

In addition, the vast majority of AIG employees do not deserve the public criticism, Geithner said.

Bernanke added that when he had found out about the AIG bonuses, he had argued against paying them, to the point of potentially suing to block the payments in advance.

Legal staff counseled against this action, on the grounds that Connecticut law provides for substantial punitive damages if the suit would fail, Bernanke said. Legal action could thus have the perverse effect of doubling or tripling the financial benefits to the AIG-FP employees.

He added, The company had been instructed to pursue all available alternatives and that the Reserve Bank had conveyed the strong displeasure of the Federal Reserve with the retention payment arrangement.

Bernanke also pledged to work more closely with the Treasury in the future to be sure such situations don't arise.

Moving forward, the Treasury is working with the Department of Justice to examine how they can recoup the bonuses, Geithner said.

The issue of excessive compensation extends beyond AIG and requires reform of the system of incentives and compensation in the financial sector, he said.

Bernanke added that the Fed, acting in its role as a creditor of AIG, has expressed concerns about the compensation practices of the company.

We have pressed AIG to ensure that all compensation decisions are covered by robust corporate governance, he said. Operating under this framework, AIG has voluntarily limited the salary, bonuses, and other types of compensation for 2008 and 2009 of the CEO and other senior managers.

In his testimony, Geithner said he would offer details about regulatory reform. In the meantime, Geithner pledged that the Obama administration and Congress would work together in order to achieve truly comprehensive regulatory reform and eliminate gaps in supervision.

Bernanke also highlighted the need for regulatory reform in his testimony.

AIG highlights the urgent need for new resolution procedures for systemically important nonbank financial firms, he said. If a federal agency had had such tools on September 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate.

He added, That outcome would have been far preferable to the situation we find ourselves in now.

Bernanke added that any future regulator should have the authority to monitor the actions of such systemically important firms.

AIG built up its concentrated exposure to the subprime mortgage market largely out of the sight of its functional regulators, he said. More-effective supervision might have identified and blocked the extraordinarily reckless risk-taking at AIG-FP.

The decision to intervene and save AIG from collapse came from the decision that its disorderly collapse could cause large and unpredictable global losses with systemic consequences -- destabilizing already weakened financial markets, further undermining confidence in the economy, and constricting the flow of credit. Geithner noted.

A disorderly failure of AIG risked deepening and prolonging the current recession, he added.

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