The near-collapse of the systemically important American International Group, Inc. (AIG) highlights broad failures of the U.S. financial system, a trio of top economic officials said Tuesday. Testifying before the House Financial Services Committee Treasury Secretary Timothy Geithner along with Federal Reserve Chairman Ben Bernanke and New York Federal Reserve Bank President William Dudley, discussed the reasons for the AIG bailout and expressed their frustration over the highly publicized bonuses.

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.

Bernanke echoed Geithner's sentiment, calling the bonuses highly inappropriate and adding that he had tried to use legal avenues to block the bonuses.

The Fed Chairman added that AIG must scrupulously avoid any excessive and unwarranted compensation.

We have pressed AIG to ensure that all compensation decisions are covered by robust corporate governance, including internal review, review by the Compensation Committee of the Board of Directors, and consultations with outside experts, Bernanke said.

Bernanke's attempted lawsuit was deemed untenable by the Fed's legal staff, Bernanke said, and could have had the perverse effect of doubling or tripling the financial benefits to the AIG-FP employees due to punitive damages.

AIG CEO Edward 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 said.

Despite the uproar over the bonuses, Bernanke defended the Fed's decision to bail out the insurance giant. The government's decision to step in and bail out AIG came in the face of unacceptable risks that its collapse would have cause to the global financial system, Bernanke told lawmakers.

Conceivably, its failure could have resulted in a 1930s-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs, Bernanke said.

Geithner also defended the bailout, and the actions of Liddy in terms of the compensation.

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.

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.

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.

New York Federal Reserve Bank President William Dudley also defended the intervention in the face of severe systemic risk.

Dudley recognized the unpleasant aspects of the AIG bailout, stating that as unattractive as parts of the bailout, including compensation, may be, they are better than the alternative of letting AIG fail.

These negative aspects have followed unavoidably from the decision to avert a systemically destructive bankruptcy, he said.

He added that he expects AIG to fully repay the loans it received from the New York Fed.

The total package of assistance that the Federal Reserve and Treasury Department have committed to AIG has established a more durable capital structure for the company that gives AIG greater time and flexibility to execute its asset disposition plan to repay government funds, Dudley told lawmakers.

He added, Notably, we have recently agreed in principle to accept preferred interests in two of AIG's large foreign life insurance subsidiaries, AIA and ALICO, in order to make repayment of our loan less dependent on forced divestitures into a depressed acquisition market.

Although it will take time, we still expect that the proceeds from asset sales should enable AIG to repay the New York Fed in full, Dudley noted.

Prior to taking over the role of New York Federal Reserve Bank President, Dudley served as the head of the Markets Group at the New York Fed.

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