As ProPublica reported Tuesday, the $2 billion class-action claims security firms, support companies like KBR Inc., and their insurance providers “routinely lied, cheated and threatened injured workers,” while flouting the World War II-era law guaranteeing coverage for private workers supporting the U.S. military.

Reporter T. Christian Miller investigated how the wars in Iraq and Afghanistan have strained the system over the last few years, but the latest complaint may be the most far-reaching yet:

The lawsuit, believed to be the first of its kind, charges that major insurance corporations such as AIG and large federal contractors such as Houston-based KBR deliberately flouted the law, thereby defrauding taxpayers and boosting their profits. In interviews and at Congressional hearings, AIG and KBR have denied such allegations and said they fully complied with the law. They blamed problems in the delivery of care and benefits on the chaos of the war zones.

The suit names Houston-based KBR, Xe Services — the security firm formerly known as Blackwater — and Dyncorp International among the defendants, along with insurance giants AIG and CNA Global Insurance, the two major insurance providers for private workers under U.S. Department of Defense contracts.

Four Texas men are included as plaintiffs, along with others around the U.S. and South Africa. Their injuries include blast wounds from explosives, infected sandfly bites, post-traumatic stress disorder and traumatic brain injury.

Washington lawyer Scott Bloch, a former U.S. Special Counsel under George W. Bush, told the Texas Independent that he first heard about contractors’ troubles with their medical claims shortly after he started his private practice. Bloch represents former Blackwater employees in a separate case filed in June, also over medical benefits.

“My experience tells me it’ll require hundreds of millions of dollarsin damages for them to wake up,” Bloch said. He hopes this class action will eventually result in criminal and internal investigations, not only into the private companies named in the suit, but the government agencies that handle their contracts.

Contractors across the country continue fighting drawn-out cases over individual claims, and a 2009 House subcommittee hearing on health benefits for war contractors has brought little change in the law.

“This is a massive scandal, this is a bigger scandal than Walter Reed — much more wide-ranging,” Bloch said. “The light isn’t shining on it. The news outlets are like, ‘Well, we want the soldier’s stories. We want the guys carrying the guns with the sunglasses.’”

Houston attorney Gary Pitts has spent years on individual Defense Base Act cases involving some of the same companies and health issues — and testified before that House subcommittee hearing two years ago. While the types of injuries are different today than they were in 2004 — fewer truckers are injured by IEDs today — Pitts said the claims system remains just as difficult to navigate.

“We’re just sloggin’ away,” Pitts said. “Who knows how long this’ll go on?”

But grouping defendants together into class-action suit is a long shot for some claims in Bloch’s complaint, Pitts said, like allegations that workers were fired in retaliation.

“The trend of the courts over 10 to 20 years has been to make it harder and harder to bring a class action,” Pitts said. “I would say the odds are very very hard.”

But she hits even harder at AIG’s regulators and the government’s extraordinary intervention. “[AIG's] complexity, its systemic significance, and the fragile state of the economy may all arguably have been reasons for unique treatment. But no matter the justification, the fact remains that AIG’s rescue broke all the rules, and each rule that was broken poses a question that must be answered,” she argues.

AIG’s regulators and regulations failed the American taxpayer, Warren says. And thankfully, the House and Senate reform bills create a much better process for monitoring systemically important firms and winding them down if they falter — a process designed precisely as a response to the wildly expensive and unruly bailouts of companies like AIG.

Now, firms like AIG need to author their own “funeral plans,” telling the government how to unwind them. Additionally, the reforms clarify the government’s process for deciding a firm needs to be shut down and then doing it, wiping out shareholders, firing management and giving counterparties haircuts. (There are differences between the House and Senate bills on the resolution authority front, differences that will be worked out in conference committee. The biggest difference is that the House bill has a $150 billion liquidation pool, funded by big financial firms. The Senate bill instructs the government to recoup its costs after the fact.)

Here is a fuller clip of the remarks from Warren, a bankruptcy professor at Harvard Law School:

When a company digs itself so deeply into debt that it cannot escape, our legal system provides a set of strict and simple rules to force the business to bear as much of the cost of its mistakes as possible and to minimize the impact on others. Of these rules, two are paramount. First, the business’s owners — its shareholders — lose everything. Second, the business’s creditors — including its bondholders and counterparties — lose money, and depending on how deep the hole, they could lose a great deal.

The rules may seem harsh, but they are fundamental to the functioning of a free market. After all, the parties that gain the most when a business succeeds should also lose the most when a business fails.

I open today’s hearing by listing the rules of bankruptcy because we are about to examine a bankruptcy that broke all the rules. In fact, the rescue of the American International Group was so extraordinary that it bypassed the entire legal process of bankruptcy. In saving AIG, the government invented a new process out of whole cloth, a parallel set of rules devised and executed for the benefit of only one company.

By the time the federal government intervened in late 2008, AIG was a poster child for the need for a well-functioning bankruptcy system. Its stock price had plummeted 79 percent in only two weeks. The sharp decline in mortgage-linked asset prices and the failure of Lehman Brothers had led to staggering collateral calls from AIG’s counterparties, and AIG simply did not have enough cash on hand to keep its doors open.

The next steps would ordinarily have been straightforward. Under the rules that applied to everyone else in America, AIG’s shareholders should have lost everything, and its creditors should have taken substantial losses. Yet even today AIG continues to trade on the New York Stock Exchange, and no creditor has lost a penny on its dealings with the company.

Put another way, under the rules that applied to everyone else in America, the costs of AIG’s mistakes should have been borne by AIG and its partners. But under this new, ad hoc set of rules, the costs of AIG’s mistakes were borne by the rest of us – the American taxpayers.

Sen. Bernie Sanders (I-Vt.) wrote the Audit the Fed amendment that was passed by the Senate on Tuesday. (EPA/ZUMApress.com)

On Tuesday, the Senate voted in a landslide to approve the Audit the Fed amendment to Sen. Chris Dodd’s (D-Conn.) financial regulatory reform proposal. Sen. Bernie Sanders (I-Vt.), the author of the amendment, has directed the Government Accountability Office to publish a report on the Fed’s books by Dec. 1, 2010, reviewing in a way that “does not interfere with monetary policy” but does “let the American people know the names of the recipients of over $2,000,000,000,000 in taxpayer assistance.”

[Economy1] But what will the Fed audit be looking for? What might it find? The shortest answer is that the audit will review and post online thus far unpublished details about the Federal Reserve’s emergency lending programs — the alphabet soup of initiatives the Fed created in haste to provide liquidity to and restore confidence in the banking sector during the financial crisis. The programs have garnered criticism as the Fed created them unilaterally, without the input of the Hill, due to the “unusual and exigent circumstance” of the crisis.

Fed audit proponents say some of those programs — most notably, the Fed’s Maiden Lane portfolio of assets bought from Bear Sterns and AIG — might seem questionable or even prove embarrassing under public scrutiny. “The transparency is nonexistent, and the possible taxpayer losses are huge. The Fed should not be in the business of managing these assets. And we’ll finally get to see what they are,” said one Democratic Hill staffer without permission to speak on the record.

The audit is roughly limited to the period of the recession, from Dec. 1, 2007 until the date that the Senate approves the final regulatory reform bill. Most of the Fed audit will be noncontroversial, even if it does make public new details about the Fed’s books. It will include a careful review of the Fed’s straightforward lending programs, each designed to pump liquidity into the market for a different kind of asset. The names are boggling: the asset-backed commercial paper money market mutual fund liquidity facility, the primary dealer credit facility, the commercial paper funding facility, the term securities lending facility. But the idea behind each is simple. Give a low-cost loan for a fixed period of time to a financial firm impacted by the seizing of credit markets. Make sure you require usable collateral for the loan. And therefore help the market while ensuring taxpayers are not on the hook. The majority of these programs sunsetted on Feb. 1, 2010, leaving the Fed’s books with few taxpayer dollars required.

So what will the audit reveal about these programs? Details. Thus far, the Fed has provided only aggregate data about its lending programs. The audit will reveal what banks received what loans, at what interest rate, in return for what collateral as well as when the Fed was paid back. The data for most programs is not expected to prove controversial. But if the Fed continually allowed one bank to post dodgy collateral, or offered beneficial interest rates to big banks but not smaller ones — that could prove questionable and could earn the Fed additional scrutiny as well as criticism.

A few emergency lending programs remain, and those will receive a thorough audit as well. Among them are the term auction facility, which auctions collateralized loans to banks (that is, lends banks cash if they put up bonds, stocks or some other asset in case they cannot pay back the New York Fed) and continues to help ease short-term lending. Its most recent auction, in March, pumped $25 billion into the market.

Another — and a program Fed audit boosters want analyzed closely — is the Term Asset-Backed Securities Loan Facility, or TALF. The program supports the market for financial products backed with streams of income from consumer loans, like student loans, car payments, credit cards and Small Business Administration loans, later expanded to include commercial mortgage-backed securities. When the credit markets seized up during the financial crisis, the market for those asset-backed securities froze as well. The Federal Reserve Bank of New York created the program to lend up to $1 trillion to people looking to buy AAA-rated asset-backed securities, and the largest part of the program closed in March. The facility only ended up issuing around $100 billion in securities and was hailed as a success.

The controversy over TALF stems from a quirk of the program’s design. When the Fed lent money to companies looking to purchase asset-backed securities, it made them put up stocks, bonds or other financial instruments as collateral. The Treasury pledged funds to buy that collateral from the Fed in case the debtors could not repay their loans. But a Government Accountability Office criticized how the Fed and Treasury vetted that collateral and slammed the program as opaque. The report said: “[Treasury] has not developed measures to analyze and publicly report on the potential purchase, management, and sale of such assets. Without such a plan, Treasury cannot measure TALF’s success in meeting its goals.”

Neil Barofsky, the government watchdog for the Treasury’s emergency programs, also criticized TALF for relying on credit ratings agencies to determine which asset-backed securities were AAA. The ratings agencies wildly misrepresented the risk of mortgage-backed securities in the run-up to the financial crisis, Barofsky noted. And the government was trusting them without performing its own due diligence. “Treasury and [Fed] should examine Moody’s assertions and develop mechanisms to ensure that acceptance of collateral in [TALF] is not unduly influenced by the improper incentives to overrate that exist among the rating agencies,” his report argued.

The most controversial part of the audit — indeed, one of the most controversial of the Fed’s programs, full stop — will be the Maiden Lane funds. (Maiden Lane is the street behind the Fed building in New York City.) The Fed created the funds to support the purchase of Bear Sterns by Wall Street giant J.P. Morgan Chase and the winding down of AIG. Maiden Lane I includes assets from Bear Sterns; Maiden Lane II includes AIG’s securities business; and Maiden Lane III includes AIG’s credit default swaps.

Maiden Lane I is the most controversial. The New York Federal Reserve Bank created the fund specifically to back the worst of Bear Sterns’ assets — the ones nobody wanted when the firm was cratering. Many on Wall Street and the Hill contend that the government overpaid for the assets to convince J.P. Morgan to buy up the rest of Bear Sterns, essentially transferring free money to the Wall Street bank. Furthermore, J.P. Morgan’s chief executive officer, Jamie Dimon, was on the board of the New York Fed at the time of the deal.

The uncertainty over the value of the fund — initially and currently — also has garnered Congressional heat. The Fed had promised that it does not expect “any net loss to the Federal Reserve or taxpayers” from Maiden Lane. But Maiden Lane I has declined in value at least 10 percent — and many on the Hill and on Wall Street do not trust the valuation of the assets, which until now have not received Congressional scrutiny. Rep. Darrell Issa (R-Calif.), for instance, has slammed the Fed over Maiden Lane. After it announced losses, he said, “the American people have a right to know what the true value of the assets they now own are and if the people controlling those assets project any further losses that may result from the Federal Reserve’s actions in bailing out Bear Stearns.”

Then, there are Maiden Lane II and III, which purchased around $50 billion of toxic assets from AIG. Most believe that the government overpaid for those assets as well — and the Hill wants more insight into how they are managed. “If the audit only looked at Maiden Lane, it would almost be worth it,” the Hill staffer said.

Underscoring the extent to which taxpayers saved bankers during the crash, the words “Washington” and “government” and “conservative” crop up constantly in the way the word “profits” used to. The letter opens by praising the government’s extraordinary measures during the financial crisis.

“[W]e have embraced new realities pertaining to regulation and ensuring that our financial strength remains in line with our commitment to the long-term stability of our franchise and the overall markets,” it says. “We became a financial holding company, now regulated primarily by the Federal Reserve and subject to new capital and leverage tests.”

But it’s no mash note to Washington. Goldman spends nearly a third of the letter on defense – clarifying its positions on its relationship with bailed-out insurer AIG, its employees’ compensation and the notion that it stoked the market for mortgage-backed securities while betting against the housing market.

It says that Goldman Sachs never “bet against [its] clients” by shorting “residential mortgage-related products in 2007.” The note argues, “[the shorts] served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”

“The firm did not generate enormous net revenues or profits by betting against residential mortgage-related products, as some have speculated,” chief executive officer Lloyd Blankfein and president Gary Cohn argue. “Rather, our relatively early risk reduction resulted in our losing less money than we otherwise would have when the residential housing.”

Yves Smith writes a good debunking of some of Goldman’s claims. My question: Why so defensive now? The note — addressed to shareholders — defends the firm’s actions from years ago against criticism it has incurred for more than 18 months.

As Lehman Brothers careened toward bankruptcy in 2008, the New York Federal Reserve Bank came to its rescue, sopping up junk loans that the investment bank couldn’t sell in the market, according to a report from court-appointed examiner Anton R. Valukas.The New York Fed, under the direction of now-Treasury Secretary Tim Geithner, knowingly allowed itself to be used as a “warehouse” for junk loans, the report says, even though Fed guidelines say it can only accept investment grade bonds.

In other words, while Geithner was head of the New York Fed, despite rules that the Fed can’t buy financial instruments that companies can’t sell in the marketplace, it was doing just that in an effort to keep Lehman Brothers solvent. Those bonds, which likely remain less than investment-grade, might well still be on the books.

Grim additionally notes that Geithner, in his position as Treasury Secretary, officially opposes a public audit of the Fed which would, not coincidentally, make public any and all worthless assets the Fed current owns or controls and what it does with its money.

Although the Fed told The New York Times earlier this month that a third party verified the market value of the bonds Lehman used as collateral for loans from the Fed, they did not specify who the third party was. Of course, Lehman’s auditors at Ernst & Young are already implicated in helping Lehman cook their books and fake the value of their derivatives, so the Fed may well have allowed a third party to determine the valuation but, as with the Goldman-AIG valuation debacle, not done a particularly good job at making sure that third party was at all independent.

According to Grim, Lehman’s own internal documents reflected the fact that, third-party valuations or not, the securities they signed over as collateral to the Fed were far from investment-grade.

In other words, the baskets of assets were created for the specific purpose of selling to the Fed for far more than they were worth.Lehman knew it too: “No intention to market” was scrawled on one of the internal presentations about the assets. A separate bank, Citigroup, later characterized the assets as “bottom of the barrel” and “junk” when Lehman tried to push them their way, according to the report.

So at least one third party thought the investments were junk.

Part of the proposed financial reform regulation would require investors to trade derivatives of the kind Lehman sold to the Fed on the open market in order to allow all investors, including the Fed, to have more information and assign them a real market-based value. It is, of course, one of the many provisions that financial companies are fighting tooth and nail, to allow them to continue marketing financial products and services they know full well are junk.

Behind closed doors, employees at AIG’s Financial Products division — the very unit whose trading had hastened the insurance giant’s collapse — were defiant, saying they were merely getting what they were due, recoiling at public accusations that they were behind their capitalizing on the company’s massive taxpayer bailout.

It’s worth reading the whole piece to get a full taste of the pomposity inherent in some of these folks, who after all, had recently contributed to the collapse of the global economy. The arrogance award, though, goes to the nameless employee who said this of taxpayers:

To be honest with you, I really hope it blows up. I think the U.S. taxpayer deserves to lose a trillion dollars over this thing for the way they have behaved.

That same guy also had some choice words for the politicians critical of AIG’s dealings:

They only care about the next election, just like we only care about the next bonus. Well, none of them cares about the country, none of us cares about the institution. They really don’t care, and I really don’t care. And frankly, if a trillion dollars gets lost, fine.

It’s unclear whether this particular angry person was aware that he had just conceded precisely how shallow he really is.

In the midst of the financial crisis, Goldman Sachs and Morgan Stanley sought licenses to become bank holding companies in order to gain access to the Fed’s emergency lending capacity. Despite the increased regulation and capital requirements, they’ve stayed “banks” while continuing to use their cash reserves in proprietary trades (i.e., investing their own money in the stock and other markets). Volcker’s proposed banking rules would end that practice, as it has the potential to drain banks reserves — and then the Fed’s reserves and, in the case of failure, the FDIC’s coffers as well.

Upon hearing that Goldman Sachs had no intention of giving up its banking license, Volcker said:

“The implications for Goldman Sachs or any other institution is, do you want to be a bank?” Volcker, a former chairman of the Federal Reserve, told the Financial Times. “If you don’t want to follow those (banking) rules, you want to go out and do a lot of proprietary stuff, fine, but don’t do it with a banking license.”

Goldman, as likely comes as no surprise, wants to go out and take risks with its money and use the Fed (and taxpayer dollars) to limit the risk that its bets are faulty. The problem is that Volcker knows full well that the last time Goldman had an absolute hedge against loss was when it convinced AIG to insure investments that were destined to go bad in order to profit off the insurance payout. He doesn’t think they should be able to do the same thing to the Federal Reserve.

House Minority Leader John Boehner (R-Ohio) got the ball rolling last week when he leaked to the Journal that he’d met with J.P. Morgan Chase CEO and Chairman (and big Democratic donor) Jamie Dimon about donating to Republicans; Dimon refused to comment. The Times picked up the gauntlet this week, quoting the BB&T CEO Kelly King — a board member of the Financial Services Roundtable:

“If the president doesn’t become a little more balanced and centrist in his approach, then he will likely lose that support [of financial companies].”

Interestingly, according to campaign finance records, King has donated exclusively to Republican candidates, and BB&T’s PAC has historically weighted its contributions in favor of Republican candidates regardless of the party in control. It sounds like a guy who doesn’t even donate to Democrats is trying to shake them down for concessions on financial market reforms based on their desire for campaign contributions — and reporters are lapping it up.

But is it true that financial companies are switching their campaign contribution allegiance to Republicans in 2010? The first (and only) concrete example offered of a company doing this is Bank of America, according to the Journal.

Through the first nine months of 2009, about 54% of donations from Bank of America Corp.’s political action committee and employees went to Republicans, according to campaign-finance data compiled by the nonpartisan Center for Responsive Politics. That was a switch from the 2008 campaign, when 56% of the company’s donations went to Democrats.

That’s true, but it’s only half of the picture. Bank of America actually operates two PACs: one out of Washington, and one out of Delaware. In 2008, the D.C.-based PAC gave 55 percent of its congressional race donations to Democrats, but 54 percent of its Senate donations to Republicans; the Delaware-based PAC split its donations to candidates down the middle, but gave 58 percent of its PAC-to-PAC expenditures to Republican causes. Overall, the $50,000 extra that the D.C.-based PAC gave to Democratic Congressional candidates was outweighed by the $87,000 extra the Delaware-based PAC gave to Republican causes.

In the 2010 cycle so far, the D.C. PAC has given 53 percent of its Congressional contributions to Republicans and 91 percent of its Senate contributions to Republicans, and the Delaware PAC gave just over two-thirds of its contributions to Republicans PACs. It’s a movement away from Democrats, but the cycle is far from over — in fact, given that it’s still primary season for contributions, it’s barely begun — and the numbers show that the Bank of America was hardly some great supporter of Democrats during the best of times. Like many other companies, what loyalty it showed to Democrats in 2008 was solely loyalty to House Democrats, not to the party overall.

The story holds true for many other major banks: Supposedly staunchly Democratic firm J.P. Morgan has a similar dual-PAC structure, and the majority of its contributions went to Republican candidates in 2008, and weren’t outweighed by the minor advantage held by Democrats in its PAC-to-PAC contributions in 2008 — nor were its second PAC’s small contributions to candidates strongly in favor of Democrats. While its PAC-to-PAC contributions in 2010 are heavily in favor of Republicans so far, its contributions to candidates are running fairly even — and the PACs have allocated less than a quarter of the 2008 cycle contributions despite strong fundraising. Dimon himself has yet to donate to a single Republican candidate in 2010.

Goldman Sachs, everyone’s favorite punching bag, hasn’t donated to a single Republican senator for 2010, and its contributions to Democratic House candidates far outpace those to Republicans. The Times says that UBS’s PAC is donating mostly to Republican candidates because of its strong support for Senate Republicans; but UBS’s donations to Democratic House members are besting those to Republicans, which is the very reason why its 2008 donations favored Democrats in the first place. The embattled AIG is one of the few companies whose donations to Democratic senators outpaced those to Republicans in 2008; that continues in 2010.

In fact, according to the Center for Responsive Politics, the PAC donations by finance, insurance and real estate companies have turned in favor of Democrats in 2010 as compared to 2008, spurred by a reversal of fortune for Republicans among commercial banks and insurance companies as well as gains for Democrats among savings and loan companies and security and investment companies. It seems a lot like the real story is that Republicans are trying to claw back a trend away from donating to Republicans in 2010, rather than spurring any movement away from the Democrats. But that would take some number crunching to figure out, rather than relying on whispers from Boehner’s office or statements from Republican bankers.

But unless you’re well-versed in the modern minutiae of the financial market, it probably didn’t help explain anything about why Treasury Secretary Tim Geithner is facing an investigation into his role in the affair.To recap Morgenson and Story:

• The people at Goldman Sachs invested in mortgage-backed securities they expected to decline in value in order to make money off the insurance claims.
• Due to a long-standing relationship, they went to AIG for a kind of insurance — credit default swaps — which were not regulated.
• They then used other companies, including Société Générale, to purchase more of the unregulated insurance that AIG might not have otherwise underwritten in order to manage its own risk.
• When Goldman’s investments declined, they submitted insurance claims for the losses, but insisted on determining the amount of their damages on their own, without any input from AIG, any auditor or the market.
• After Goldman got as much money out of AIG as they thought they could, their stock analysts issued a report about how AIG was bleeding cash and their creditors wouldn’t negotiate, without mentioning that AIG was bleeding cash because of them and that Goldman was the creditor that wouldn’t negotiate. AIG’s stock tanked.
• The government stepped in, took an 80 percent share in AIG and then paid Goldman and the other creditors all the money they’d asked AIG for at the start of the negotiations in 2007, without using their power to force AIG’s creditors to negotiate.

When the federal government, including then-Treasury Secretary Hank Paulson (who once served as chairman and CEO of Goldman Sachs), directed AIG to pay Goldman exactly what it wanted, it overrode significant and long-standing misgivings by AIG’s lawyers and accountants that Goldman’s estimates of its losses were correct. Morgenson and Story note that the prices on the very securities for which Goldman demanded insurance payments have since rebounded — but under the terms of the deal struck by the federal government, Goldman doesn’t have to pay a cent of its insurance settlement back to either AIG or the taxpayers. That’s quite the sweetheart deal for Goldman Sachs, if not taxpayers.

Now-Treasury Secretary Tim Geithner’s role in the November payouts is under investigation; his spokesperson said last month that then-New York Fed Chair Geithner officially recused himself from participating in the AIG bailout after Nov. 24, 2008 — the date of his nomination to Treasury — and had begun to insulate himself from such decisions “weeks earlier in anticipation of his nomination.” The Presidential election was held Nov. 4, 2008, and the plan to give Goldman everything it wanted was made official 6 days later, on Nov. 10. Either Geithner was insulating himself from his own job weeks before the election, or he was as involved in the negotiations as his detractors have charged.

Documents have recently emerged showing that the N.Y. Fed, starting as early as Geithner’s Treasury nomination announcement, worked with AIG to prevent full disclosure of how the bailout money it received in November went straight to companies like Goldman Sachs, Société Générale and Deutsche Bank, among others. The order to AIG from the government not to negotiate with its creditors may have cost U.S. taxpayers $13 billion; it was only under pressure from the SEC that AIG made public in March 2009 (after Geithner’s confirmation) the banks to which it had transferred its bailout funds.

As the N.Y. Fed staffers — who, despite his recusal, still worked for Geithner — were pressuring AIG to refrain from disclosing the government’s demands on behalf of Goldman and the secondhand amount Goldman received from the bailout, Geithner was amending his tax returns and paying back taxes in order to survive his confirmation process. Revelations that he’d also used his position at the N.Y. Fed to preserve the financial interests of Goldman Sachs over taxpayers or the company in which the government had taken a majority stake might have scuttled his nomination entirely. These days, many Democrats seemingly think that perhaps it should have.

Rep. Dennis Kucinich (D-Ohio) and Treasury Secretary Timothy Geithner (WDCpix)

To hear Treasury Secretary Tim Geithner tell the tale, the federal officials negotiating the taxpayer bailout of American Insurance Group had no choice but to provide full payment to the company’s trading partners, including Goldman Sachs.

“There was no way, financial, legal, or otherwise, we could have imposed haircuts, selectively default on any of those institutions, without the risk of downgrade and default,” Geithner told lawmakers on the House Oversight and Government Reform Committee last week.

[Economy1]Don’t tell that to Rep. Dennis Kucinich. The Ohio Democrat — who heads the committee’s domestic policy subpanel — says that federal officials had plenty of leverage to push Goldman for a lesser payout, but simply chose not to use it. Indeed, an investigation by his office, Kucinich says, found that Goldman was already preparing to take less than 100 cents on the dollar for the complex, AIG-backed securities it held at the time. He’s charging that Geithner — who headed the New York Federal Reserve when it funneled billions of dollars through AIG to other firms — simply put Goldman’s interests above those of taxpayers.

“There was only one way for Goldman Sachs to get all of the billions they claimed from AIG, and that was if the New York Fed voluntarily agreed to give it to them,” Kucinich, the populist former mayor of Cleveland, said in a little-noticed exchange with Geithner last week. “If the Fed had fought for taxpayers, Goldman would have had to take some losses and the cost to the people could have been minimized.”

Some legal experts agreed. “This ‘legally obligated’ stuff is a lot of nonsense,” said an expert on the Wall Street bailout who wasn’t authorized to speak on the record. “They [Fed officials] are only as legally obligated as they want to be.”

That Goldman is such a powerful player in Washington politics (then-Treasury Secretary Henry Paulson once headed of the firm) could only have contributed to the decision to pay on par, the expert noted. “The idea of imposing a haircut [on Goldman] just kind of wasn’t in the bloodstream of the people involved.”

The controversy stems from the $27 billion the Fed paid in late 2008 to settle roughly $62 billion in insurance contracts that AIG held with a number of large firms. As the mortgage market tanked, AIG had paid out billions to those companies — collateral based on the falling value of the securities. But the banks were all scrambling to cash out on the balance because they were allowed to make more collateral calls as AIG’s credit rating was being downgraded — and because the value of those mortgage bundles was still sinking fast. Effectively, the Fed scrapped the insurance contracts and bought the securities outright. “We paid the fair market value at that time for the assets,” Geithner said last week.

Critics of that arrangement have long wondered why the Fed agreed to pay the full amount, rather than negotiate a better deal for the taxpayers footing the bill. More recently, the scandal has surrounded news that the Fed, at the time, tried to hide those full payments from the public.

The gist of Kucinich’s beef, which focuses just on Goldman’s contract, is more nuanced: Because of a months-long disagreement with AIG over the value of the underlying securities, Goldman took out supplemental insurance policies on $2.5 billion it feared it would lose if AIG failed — much like seniors take out supplemental health policies to cover services that Medicare doesn’t. Goldman executives have said repeatedly that, aided by those policies, the firm was fully protected in the event that AIG went under.

“If AIG had defaulted on its obligations, our shareholders would have been protected against loss because we were fully hedged,” Goldman spokesman Michael DuVally said in an email Friday. “But, because AIG could meet its obligations, it avoided default.”

Left unmentioned, Kucinich says, is that Goldman’s supplementary policies were invalid in the case of a government takeover of AIG — which was the only way the insurance giant was ultimately able to meet its obligations. Translation: After the government stepped in to rescue AIG, Goldman was in a position to lose $2.5 billion, leaving the Fed with a good deal of leverage to negotiate lower payments on behalf of taxpayers.

“The New York Fed had a lot of leverage — a lot of leverage — to negotiate a reduction which would have saved taxpayers billions,” Kucinich told Geithner.

He wasn’t the only lawmaker making a stink about the deal. Rep. Stephen Lynch (D-Mass.) blasted Geithner over the Goldman payments, arguing that Fed officials had “every opportunity” to negotiate a better arrangement for taxpayers.

“The commitment to Goldman Sachs trumped the responsibility that our officials had to the American people,” Lynch said.

Geithner, for his part, fought back against all the critics. The Treasury secretary argued that — because current law doesn’t allow regulators to unwind troubled investment houses the way they can unwind failing commercial banks — officials were left will little choice but to prop up AIG and make good on all of its financial obligations. “We faced a very simple choice: Let AIG default or prevent it,” Geithner said. Allowing the former, he maintained, would have led to an economic collapse much worse than the one that occurred.

“Thousands of more factories would have closed their doors,” he testified. “Millions more Americans would have lost their jobs. The value of Americans’ houses and savings would have fallen even further than they did at that time. People would have rushed to take their money out of banks. It would have brought about utter collapse.”

A March 2009 report from the special inspector general of the Troubled Asset Relief Program indicates that AIG’s trading parties were well justified to fight for full payment on behalf of their shareholders. “[F]rom the counterparties perspective, offering a concession would mean giving away value and voluntarily taking a loss, in contravention of their fiduciary duty to their shareholders,” the report states. “They were contractually entitled to the par value of the [securities].”

But some critics of the Goldman payments have argued that, shareholders or none, the giants of Wall Street should have shown more willingness to absorb the consequences of a financial meltdown caused largely by them.

“Workers around the country are being asked to take pay cuts and accept shorter work weeks so that colleagues won’t be laid off,” former New York governor Eliot Spitzer wrote last year. “Why can’t Wall Street royalty shoulder some of the burden?”

Instead, champagne-sipping Goldman employees are celebrating their bonuses this month.

Kucinich, representing a part of the country decimated by foreclosures in recent years, preferred to focus his criticisms not on the firms, but on the federal officials charged with protecting the public.

“The government gave Goldman Sachs more than Goldman Sachs had any right to expect while at the same time giving no financial relief whatever to millions of Americans facing a foreclosure crisis,” he told Geithner. “If that doesn’t illustrate what the New York Fed thought it was working for — or who it was working for — I don’t know what does.”