Treasury Department officials could have avoided the American International Group Inc. bonus controversy if they had carefully examined the company’s compensation system, investigators say.

The Office of the Special Inspector General for the Troubled Asset Relief Program published that conclusion along with a finding that, rather than exercising oversight over compensation, Treasury let the Federal Reserve handle the matter.

The problem with delegating the matter is that Treasury had “limited communications” with the Federal Reserve, SIGTRAP officials write.

SIGTARP has based the report on an investigation into the extent of knowledge and oversight by the Federal Reserve and Treasury officials concerning AIG bonus plans, including retention payments issued to AIG Financial Products unit staff members.

AIG Financial Products’ disastrous derivatives activities forced AIG to seek a multi-billion-dollar government bailout that included TARP aid.

“Considerable Congressional and public outcry resulted from AIG making $168 million in retention and award payments to a large group of its employees in March 2009,” SIGTARP officials write in their report.

In October 2008 after the government arranged to shore up AIG, Federal Reserve Bank of New York officials began looking at AIG companies’ decentralized compensation and bonus plans, the investigators write.

The arrangements had a total value of about $1.75 billion.

“Although [New York Fed officials] learned of the size of the impending payments and their timing among other things, it is unclear whether FRBNY officials knew that thousands of dollars in payments would go to non-essential AIGFP support employees, such as kitchen and mailroom employees,” officials write.

“Treasury invested $40 billion of taxpayer funds in AIG, designed AIG’s contractual executive compensation restrictions and helped manage the government’s majority stake in AIG for several months, all without having any detail information about the scope of AIG’s very substantial and very controversial executive compensation obligations,” officials write.

“Treasury’s failure to discover the scope and scale of AIG’s executive compensation obligations, in particular at AIGFP, potentially resulted in a missed opportunity to avoid the explosively controversial events and created considerable public and Congressional concern over the retention payments,” officials write.

The SIGTARP officials say that, while they see no indication that Treasury Secretary Timothy Geithner “had personal knowledge of the AIGFP bonuses until March 10, 2009, three days before they were paid, this too suggests a failure of communication.”

“In light of the political sensitivities associated with the bailout of AIG, both as President of FRBNY and subsequently as Secretary of Treasury, it was necessary that Secretary Geithner be informed by his staff, in a timely manner, of such sensitive and significant information,” the officials write.

When the Treasury Department agreed to provide $30 billion in additional support for AIG, it had a possible opportunity “to compel renegotiation of the AIGFP retention payments,” the officials write.

The failure to adequately inform Geithner is “a failing at both FRBNY and Treasury to identify adequately the significance of an issue that has been identified as one… ‘not easy for the Fed and Treasury to defend’ and to inform their leadership,” the officials write.

The officials recommend that the Treasury Department take steps to work with Federal Reserve officials to understand AIG compensation and set policies for oversight.

But the SIGTARP officials also write that the AIG Financial Products retention payments were consistent with the law and not governed by executive compensation restrictions that were placed on AIG executives as part of the government’s TARP assistance agreement.

“Several legal opinions concluded that the payments were contractually required,” SIGTARP officials write.

After the public outcry erupted, AIG asked for a return of the payments. “Although AIG received a commitment from some employees to repay a portion of the retention awards, collection has been incomplete due to certain employees leaving AIG and reported concerns of employees who remain at AIG regarding the status of future payments under the AIGFP retention plan,” officials write.

The SIGTARP report was released in advance of a congressional hearing today by the House Committee on Oversight and Government Reform, which is looking into the bonuses at AIG.

Rep. Edolphus Towns, D-N.Y. the committee chairman, put out a written version of his opening remarks before the hearing.

“What is the justification for giving bonuses to people who drove their own firms off a cliff and very nearly crashed the US economy?” Towns asks in the written version of his remarks. “Wasn’t there something seriously out whack here?”

The SIGTARP “found that AIG’s compensation used to be weighted toward long-term incentives that were payable only at retirement, the classic ‘golden handcuffs,’” Towns says. “But in 2007, when losses began to mount, AIG’s new management decided to “update” their compensation plans. The golden handcuffs were replaced by golden envelopes. The era of instant gratification had arrived at AIG.”