Oct. 14 (Bloomberg) -- The Treasury Department failed to monitor “explosively controversial” executive bonuses paid by American International Group Inc. after bailing out the insurer, said the chief watchdog of the U.S. financial rescue program.

“Treasury paid scant attention to the pay structure” for four months after committing $40 billion in November, said Neil Barofsky, special inspector for the Troubled Asset Relief Program, in congressional testimony today. “This was a failure of oversight by Treasury, which essentially abdicated its role” to the Federal Reserve, Barofsky told the House Oversight Committee.

AIG awarded about $165 million in March to employees in the unit blamed for the insurer’s near-collapse. President Barack Obama called the bonuses an “outrage.” The New York-based insurer said the pay was needed to keep staff to unwind money- losing derivative trades that regulators said could destabilize the global financial system.

Treasury Secretary Timothy Geithner may not have known about the bonuses until March 10, three days before they were handed out, Barofsky said. Treasury committed an additional $30 billion to AIG earlier that month.

Officials at the New York Fed, which provided an $85 billion credit line in September 2008 in AIG’s first rescue, learned of the AIG bonus program in October, while Geithner was still president of the bank, Barofsky said. The Fed credit line was reduced to $60 billion after the Treasury committed funds.

‘Political Sensitivities’

The Fed, as a creditor, was concerned with loan repayment, and didn’t realize the bonuses would be a “big deal” to lawmakers and the public, Barofsky said.

“This was sort of the problem of the outsourcing of oversight to an entity that just doesn’t have the political sensitivities, particularly at that time, that you would expect from Treasury,” Barofsky said today.

Representatives Darrell Issa, a Republican from California, said during the hearing that “we have a secretary of Treasury who failed to know what he should have known, failed to do what he should have done and failed to give us transparency.”

Meg Reilly, a spokeswoman for Treasury, said the U.S. recouped the $165 million in retention payments by imposing a fee on AIG of the same amount and deducting $165 million from the $30 billion facility. Deborah Kilroe of the New York Fed declined to comment.

Kenneth Feinberg, Obama’s special master on compensation, told AIG to reduce a $198 million payment yet to be made to the Financial Products derivatives unit, according to the Barofsky report. Feinberg didn’t specify how much the payments should be reduced, Barofsky said.

Kitchen Assistant

Retention payments went to “non-essential” Financial Products staff including $7,700 to a kitchen assistant and $87,500 for an administrative assistant, Barofsky said.

AIG’s incentive plans were a “mess,” Barofsky told Congress. The company had more than 600 bonus programs and was “unable to obtain a full understanding of their compensation plans because AIG does not have an integrated information system,” Barofsky’s report said.

“Bonuses were recklessly awarded, without thought for who was footing the final bill,” Representative Elijah Cummings, a Maryland Democrat who requested the Barofsky audit, said yesterday in a statement.

Of the $45 million in bonuses that AIG executives pledged in March to return, less than half has been repaid, according to the report. Employees were asked by former Chief Executive Officer Edward Liddy to return some payments amid a public backlash that included death threats to AIG employees. About $19 million had been returned as of Aug. 31, Barofsky said. AIG told Barofsky it could be difficult to recover funds from recipients who are no longer with the company.

‘Considerable Progress’

“Employees have until the end of the year to fulfill their commitments to return a portion of their March 2009 payment,” Christina Pretto, an AIG spokeswoman, said yesterday in a statement. The insurer expects the workers to honor their commitments, she said, and they have made “considerable progress” in winding down the unit.

As of March, Financial Products employees had lost about $790 million in potential future compensation because of declines in the value of the operation’s trades, Barofsky said. After losses in 2007, AIG revised compensation plans to move away from the so-called golden-handcuff approach that postpones rewards until retirement, he said.

“The golden handcuffs were replaced by golden envelopes,” Committee Chairman Edolphus Towns, a New York Democrat, said today at the hearing in Washington. “The era of instant gratification had arrived at AIG. Long-term incentives were rejected in favor of short-term gains.”

‘Contractually Binding’

Barofsky said AIG committed to payments before the company accepted a rescue and that the agreements are “contractually binding.” Feinberg, who has authority to limit compensation for the company’s highest paid workers, has indicated he’ll demand a return of retention awards from “individuals subject to special master review,” Barofsky said.

Feinberg, who formerly oversaw the September 11th Victim Compensation Fund, is expected to announce his decisions for seven firms’ 25 top-paid employees later this month. In addition to compensation at AIG, Citigroup Inc. and Bank of America Corp., he’s overseeing pay at Chrysler Group LLC, Chrysler Financial Corp., General Motors Co. and GMAC Inc.

To contact the reporter on this story: Hugh Son in New York at hson1@bloomberg.net

Last Updated: October 14, 2009 13:42 EDT