By John W. Schoen Senior producer
updated 3/16/2009 6:00:03 PM ET 2009-03-16T22:00:03

If President Barack Obama wants to find a scapegoat for the mess at American International Group, he needs only to look east from the White House to the halls of Congress.

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That's where the legislation was enacted that laid the groundwork for AIG's collapse, its subsequent multibillion-dollar bailout and even the millions of dollars in bonuses being paid to AIG executives that have so outraged Obama, members of Congress and taxpayers.

Call it the law of unintended consequences.

The controversy boiled over Monday when Obama took aim at the bonuses going to executives who oversaw the risky bets that sank the giant insurer.

"It's hard to understand how derivative traders at AIG warranted any bonuses, much less $165 million in extra pay," Obama said. "How do they justify this outrage to the taxpayers who are keeping the company afloat?"

AIG has taken out $170 billion in federal funds, and federal officials overseeing the company say it is not out of the woods yet. The backlash intensified over the weekend when the company, now 80 percent owned by U.S. taxpayers, said it was locked into paying $165 million in bonuses to key executives.

Members of Congress Monday echoed voter outrage at the big rewards being reaped by the architects of the financial flameout of one of the world's biggest insurance companies.

“We've asked the car dealers to restructure their organization, including workers restructuring their union contracts in order to save the auto industry,” said Sen. John Cornyn, R-Texas. “We ought to be asking the leadership at AIG to make the same kind of concessions to save AIG and the taxpayers' dollars.”

But experts in executive compensation say those contracts, written before the government stepped in to bail out AIG, would be difficult, if not impossible, to break.  Challenging those contracts might end up costing AIG and the government even more money including legal fees, according to attorney Aliza Herzberg of Olshan Grundman Frome in New York.

“These are contracts from a year and a half ago," she said. "We have to live by them.”

The employment contracts became so complex, with pay packages consisting of stock options and other forms of deferred compensation, largely because of Congress' attempts to control soaring executive salaries. In 1993, Congress limited the tax deduction companies could take for cash payments to $1 million. The result was a cottage industry of lawyers, consultants and advisors who structure even bigger pay packages with creative legal strategies that now make the AIG bonuses difficult to rescind.

“Before Congress got involved we used to give them a $2 million salary and a corporate jet,” said Lynn Stout, a UCLA professor who specializes in corporate governance and securities regulation. “And it was much cheaper and safer.”

Congress played an even bigger role in the mess that forced the government into a taxpayer-funded bailout of AIG to stem a potential global financial meltdown.

AIG and the “counterparties” it did business with are reeling because of a type of insurance policy known as a “credit default swaps.” Though the contracts governing these exotic investments are complex, their basic idea is very simple. Sellers of these securities promise to pay any losses to a bondholder in the event a bond issuer dafaults and fails to pay back the original investment. In return the buyer pays a premium to the issuer of the policy, just as a homeowner pays a premium for fire insurance.

That’s where the similarity ends. Unlike your homeowners insurance, credit default swaps are  unregulated. Investors were allowed to buy insurance on bonds they didn’t even own, and companies like AIG were allowed to write credit insurance many times over on the same bond. These bonds, many of them backed by subprime mortgages, often were rated triple-A, so no one expected them to default. Collecting premiums looked like easy money.

But when the housing market began to unwind, AIG had to begin making good on those credit default swaps. Worse, instead of just paying once, it had to pay many times over for the same defaulted bond. That became the financial equivalent of paying a dozen people for the full cost of replacing each home wiped out by a hurricane.

Because these risky bets were unregulated, none of the government agencies that were supposed to make sure the financial system was sound, from state insurance regulators to the Federal Reserve, were fully aware of just how much risk was in the system.

There were also no regulations to prevent AIG from making what Fed Chairman Ben Bernanke told CBS News Sunday were “all kinds of unconscionable bets."

“It's absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators but which we have no choice but to stabilize or else risk enormous impact, not just in the financial system but on the whole U.S. economy,” he said.

In fact, it was a law approved by Congress in 2000 that allowed companies to place tens of trillions of dollars of these risky credit default swap bets.

After the 1998 collapse of Long Term Capital Management, a giant hedge fund that pioneered the use of derivatives, the Fed engineered a rescue to prevent the unwinding of risky bets from spreading to the larger financial system. That brought calls for tighter regulation of derivatives, including a push for greater derivatives regulation at the Commodity Futures Trading Commission, led by a former Wall Street attorney named Brooksley Born. 

But strong opposition to the proposal from then-Fed Chairman Alan Greenspan and senior Clinton administration officials sank the idea. On Dec. 21, 2000, President Clinton signed into law the Commodity Futures Modernization Act, which further eased restrictions on derivatives like credit default swaps.

“For at least 150 years, these sorts of gambling contracts were unenforceable if they weren’t traded on an exchange,” said Stout, the UCLA professor. “We eliminated 150 years of insurance regulation and derivatives regulation all in the name of rocket science and financial engineering.”

The new law cleared the way for an explosion in credit default swaps. In the first half of 2001, there were $632 billion in credit default swaps outstanding, according to the International Swaps and Derivatives Association. By the second half of 2007, that number was up 100-fold — to more than $62 trillion. Now, as the government tries to unwind the mess at AIG, much of tax money pumped into AIG has quickly flowed out to dozens of “counterparties” — the companies, investment funds, municipalities and others who bought credit default swaps from the insurance giant.

“AIG entered a lot of speculative derivatives gambles with banks that were operating in the role of a bookie who made bad bets,” said Stout. “And our taxpayer funds went to pay off the bookies.”

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