AIG CEO Edward Liddy testified under oath recently, explaining why the retention bonuses were given, and that both the Federal Reserve and the Treasury Department approved them. The basic justification was that they were required by contracts signed with the employees in March 2008. Under the laws of Connecticut that applied, if AIG failed to pay, the employees could have sued and most likely collected three times the amount specified in the contracts as punishment for the initial non-payment. If AIG were in bankruptcy the contracts could have bee voided, but the government made the decision to avoid bankruptcy with a bailout.

Aside from the contractual responsibility, Liddy needed the expertise to wind down AIG’s complex derivatives operation. The goal was not to retain the executives for the long term, but rather to get rid of them quickly after an orderly shut down. No bonuses were given for prior bad management. The objective was to reduce the risk to the taxpayer in the bailout.

A partial transcript of the testimony is at CNN. I cannot locate a full transcript. The quotes below are from this transcript, but some of the information is not included. The complete video of the testimony is on the C-SPAN site.

Liddy was a retired insurance company executive brought in by the government to clean up the A.I.G. mess. He had no role in creating the mess, and his total compensation for tackling the job is $1.

“We weigh every decision we make with one priority in mind. Will this action help our ability to pay monies back to the government or hurt it? Although we have wound down more than $1 trillion in the portfolio of AIG Financial Products, roughly a third from its peak, the unit that is at root of our financial problems, that portfolio remains very large — $1.6 trillion. And it continues to contain substantial risk.

The financial downside for taxpayers is potentially very large, and it’s very real. And that’s why we’re winding down that business as quickly as possible.

To prevent undue risk exposure in the meantime, AIG has made a set of retention payments to employees based upon a compensation system that prior management put in place at the end of ’07 and the beginning of 2008. Payments were made to employees in the Financial Products unit that caused many of AIG’s problems, and Americans are asking quite simply, why pay these people anything at all.

Here’s why. I’m trying desperately to prevent an uncontrolled collapse of that business. This is the only way to improve AIG’s ability to pay taxpayers back quickly and completely and the only way to avoid a systemic shock to the economy that the U.S. government help was meant to relieve.” Edward Liddy [op cit]

The bonuses were contractual agreements. The bonuses were to be paid when the execs succeeded in shutting down those operations. After the bonuses were paid, the executives were out of a job, since what they had been doing was then eliminated. Eleven executives shut down their operations, thereby meeting the conditions required, receiving the bonuses they earned, and then leaving.

AIG had a financial division that put the company into deep trouble by trading credit default swaps (CDS). CDSs are basically insurance policies to protect against a company, e.g., Goldman Sachs, going bankrupt. This was a disaster. All of the staff responsible for CDS trading were fired, both in the general management of AIG and in the Financial Products division. Those responsible received no bonuses and are long gone. Of AIG’s 115,000 employees, only about 20 were directly involved in CDS trading.

What is at issue are the 23 sections of in AIG Financial Products that were trading other derivatives, which were not part of the CDS disaster. Derivatives are complex investments that require day-to-day management buying and selling hedges on the positions. There were $1.6 trillion invested in other derivatives. Abandoning effective management of those investment could have meant losses of hundreds of billions of dollars. The bonus plan was $165 million. When Liddy was induced out of retirement to try to recover AIG, he decided that it would be extremely risky to try to wind down the other derivatives without the key executives who ran those operations, hence the retention bonuses. Eleven of the execs have since finished their jobs, were paid the bonuses as promised, and left. They had fulfilled their contractual obligation.

Under questioning from chairman Frank, Liddy made clear that no performance bonuses were paid:

“LIDDY: Congressman, I — I think the contracts that you are reading from have to do with performance bonuses. No performance bonuses at F.P., zero. It’s a different issue than the retention bonuses, where we basically said to people, “You have a job. That job’s going to go away after you wind down the book of business that you manage. If you’ll stay”…

FRANK: So you’re talking about the only bonuses that were paid recently were the retention bonuses?

LIDDY: Yes.

FRANK: There were no other bonuses paid?

LIDDY: Not — not at AIGFP. No, I don’t believe so. “

Liddy explained that the Treasury Department agreed that AIG should interface with the Federal Reserve in developing the bailout plan. Fed representatives attended all of the AIG Board and Compensation Committee meetings at which the bonus plans were developed. The Fed was fully aware of all the plans from the start.

“KANJORSKI: Am I to understand you’re saying that Chairman Bernanke or his designated person at the Federal Reserve was informed that you were going to make these payments and acquiesced in that decision?

LIDDY: Yes. Everything we do, we do in the partnership with the Federal Reserve. The Federal Reserve is at our board meetings, at our compensation committee meetings, at our various meetings on strategy. And they have the ability to weigh in either yea or nay on anything that we decide.”

Present Treasury Secretary Geitner was in charge of the New York Fed at the time the meetings occurred. Senator Chris Dodd said that he had put language into the recovery bill that prohibited the bonuses, but that the language had been taken out by the House/Senate Conference Committee for reasons he did not know. A day later Dodd admitted that actually he had taken out the language based upon a request from the Obama Administration. A day after that he revealed that it was the Treasury Department that had requested the removal of the prohibition on bonuses.

Inquiries were made as to whether lower paid employees could have been hired to wind down the $2.6 trillion in A.I.G. derivatives trading. Liddy explained that the position required highly specialized day-by-day trading, and that the risk of handing it to new staff was unacceptable. Paying $165 million to save $2.6 trillion was the lower risk strategy.

The strategy was justified. Mr. Liddy, an independent expert fully cognizant of the details of the situation determined it was best. The Federal Reserve attended every meeting and it was their judgment as well. The Treasury Department intervened to block legislation that would have upset the strategy, so clearly they too agreed it was justified. All agreed it was the best approach.