With 2009 coming to a close and the stock market having rebounded from its March low, “Wall Street is ready to pat itself on the back for its huge gains with big bonuses.” Despite the brouhaha caused by bonuses in the last year — and the role that perverse pay incentives played in bringing about Wall Street’s collapse — large financial institutions have been setting aside billions for bonus payments, and in 2009 may eclipse the record compensation levels of 2007.

This makes Steven Brill’s upcoming New York Times Magazine article (already available online), which examines Special Master for Compensation Kenneth Feinberg’s quest to craft pay packages for firms receiving extraordinary government help, particularly timely. Brill focuses especially on AIG, and Feinberg’s struggle to not only assuage public anger over the AIG bonus pool, but to keep at bay a variety of government players intent on influencing his final decision.

Feinberg wanted to ensure that AIG’s compensation correlated to the long-term strength of the firm by tying it to the company’s stock performance. However, Brill wrote that “Feinberg’s push for long-term accountability was met with what Feinberg calls ‘intense pressure’ from officials at the Treasury Department and from the Federal Reserve Bank of New York”:

Officials at Treasury weighed in on A.I.G.’s side, according to Feinberg. Herbert M. Allison, the assistant secretary for financial stability, and the official to whom Feinberg reported day to day, confirms pressing Feinberg to consider, he recalls, “the fact that we were dealing with a highly volatile stock that seemed to the employees to have a less than reliable value”…Those at the Fed were even more insistent that Feinberg make exceptions for A.I.G.

Feinberg subsequently allowed some employees at AIG to receive up to $1.5 million in cash bonuses.

Of course, both AIG and its government allies argued that huge pay packages are necessary for AIG to rebound to profitability and pay back the government. However, a new study highlighted by the Huffington Post’s Grace Kiser refutes that very notion. In fact, Raghavendra Rau and Huseyin Gulen of Purdue University and Michael Cooper of the University of Utah found that, between 1994 and 2006, “the 10 percent of companies with the most highly paid CEOs earned unusually low returns in both the near- and long-term.”

“Overall, our results show a strong negative relation between pay and future returns,” the researchers wrote, adding that highly-compensated CEOs tend to become overconfident, engaging in “wasteful capital expenditures and empire building.” So it would appear that Treasury and the Fed’s pressure was based on an entirely faulty premise, but some AIG executives will still end the year with a huge payday because of it.

The Hill today has some details about how little oversight American International Group (AIG) had before it blew up, requiring a $180 billion taxpayer-funded bailout. Evidently, “in the eight months before AIG received a taxpayer bailout…top officials at the firm’s main federal regulator paid scant attention to the troubled insurer”:

Then Office of Thrift Supervision (OTS) Director John Reich and then Deputy Director Scott Polakoff held no meetings dedicated to AIG until a 45-minute conference call on Sept. 15, according to a review of 2008 calendars. The next day, AIG got $85 billion as part of a bailout that has since more than doubled. Overall, a review of calendars for six key agency officials…indicates that AIG garnered little attention from high-ranking OTS officials in Washington.

For what its worth, OTS has already said that it did a lousy job keeping track of AIG’s activities. But this report also speaks to the larger problem of gaps in the regulatory framework.

The trouble with a firm like AIG is that it is immensely complicated, and operates in many different spheres within the financial system. It began as an insurance company, but wound up grafting on a hedge fund and selling credit default swaps (CDS), which are not a traditional insurance product. Thus, it falls cleanly under no agency’s direct jurisdiction, and trying to blame one agency for the company’s downfall doesn’t really get to the crux of the problem.

So what can be done to ensure that a second AIG doesn’t come along? Yesterday, Treasury Secretary Tim Geithner took a good first step by announcing that he “is asking Congress to extend its oversight of the financial system to include the shadowy market of derivatives,” including CDS. Under the plan “companies like AIG would have to prove they have enough reserve capital to support the sale of derivatives.” Provided that regulators actually follow through with their responsibilities, this will certainly help.

Also, this is one more reason that the financial system could use a systemic risk regulator, which would be able to watch for systemically dangerous financial activity, regardless of where it’s originated. An entity watching for systemic risk would provide one more buffer against firms crossing into new territory. And after seeing what these firms were able to do to the economy, we can use all the buffers that we can find.

Today, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner testified before Congress regarding the AIG bonus debacle. In his opening statement, Bernanke expressed remorse that AIG has not been nationalized:

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

Indeed, a lot of the AIG mess could have been prevented if it was just nationalized at the beginning. Instead, it’s been kept alive by infusion after infusion of federal funds, without the government ever exercising any of the control that should come from an 80 percent ownership stake. As Kansas City Fed President Thomas Hoenig pointed out, we’ve simply nationalized institutions “piecemeal, with no resolution of the crisis.”

Bernanke’s wider point, though, is that there is no formal process that currently exists for nationalizing huge, complex financial institutions. According to a Washington Post report, the administration is well aware of this, and is considering a plan that would grant Treasury such authority:

Besides seizing a company outright, the document states, the Treasury Secretary could use a range of tools to prevent its collapse, such as guaranteeing losses, buying assets or taking a partial ownership stake. Such authority also would allow the government to break contracts, such as the agreements to pay $165 million in bonuses to employees of AIG’s most troubled unit. The Treasury secretary could act only after consulting with the president and getting a recommendation from two-thirds of the Federal Reserve Board, according to the plan.

According to Reuters, the FDIC has also “hinted it could take on that job, with Chairman Sheila Bair saying recently that the agency’s model for failed banks works well.” Either way, the change would have to be passed through Congress.

Nationalizing these giant firms would not be easy or inexpensive. But, there is not much else that can feasibly be done with giants like AIG or Citigroup — they’re too-big-to-fail and in no shape to carry on as they once did. If nationalized, AIG and firms like it could be wound down and broken up, and hopefully a new regulatory framework will be implemented to keep firms from growing so large in the future.