Treasury Department “Pay Czar” Kenneth Feinberg says he is about to design compensation guidelines for second-tier executives at the seven biggest Troubled Asset Relief Program aid recipients.

Feinberg, the special master for TARP executive compensation, talked about the new executive compensation effort today at a House Oversight and Government Reform Committee hearing entitled “Executive Compensation: How Much is Too Much?”

Last week, Feinberg set strict limits on up-front, cash compensation for the top 25 executives at each of the seven biggest TARP participants. One of the companies affected is American International Group Inc., New York (NYSE:AIG).

Feinberg told lawmakers at the hearing that he is now implementing the section of the pay czar law that requires him to regulate the compensation of “executives 26 to 100″ at each of the seven big TARP participants.

“By the end of this year, we will have designed and implemented not individual pay packages for 26 to 100, but overall compensation structure for employees 26 to 100 in these seven companies,” Feinberg said.

The pay czar law also permits the Treasury secretary to ask Feinberg to set 2010 compensation levels for employees 1 to 25 at the seven big TARP participants.

Feinberg said he hopes his compensation decisions will set a good example for Wall Street, but he rejected the idea of having the pay czar regulate compensation at companies other than the seven big TARP participants.

“These seven companies are owned by the taxpayer,” Feinberg said.

Congress created the TARP pay czar position in the hope of helping the taxpayers get their money back, not because of a belief that the government should micro manage compensation at private companies, Feinberg said.

The hearing topic inspired other witnesses to give colorful, emotional testimony about what they believe to be flaws in the government’s approach to bailing out big companies and compensating those companies’ executives.

Russell Roberts, a professor of economics at George Mason University, said the government should have let more giant financial companies fail.

“When your teenager drives drunk and wrecks the car, and you keep giving him a do-over–repairing the car and handing him back the keys–he’s going to keep driving drunk,” Roberts said. “Washington keeps giving the bad banks and Wall Street firms a do-over. Here are the keys. Keep driving. The story always ends with a crash.”

The pay czar system is arbitrary, and it distracts the American people from the real problem, which is the existence of the bailouts, Roberts said.

“We’ve got seven firms being told they’ve got to behave,” but “the rest of the firms have gotten away with” taking excessive risk, because the expectation that the government would bail them out turned out to be correct, Roberts said.

Propping up troubled companies in the hope of recouping aid already paid could cause huge, new problems, Roberts added.

When looking at some companies, such as AIG, “maybe we ought to cut our losses and get out.”

William Black, an associate professor of economics and law at the University of Missouri – Kansas City, said badly designed compensation programs, and accounting fraud designed to pump up performance-based compensation, are the real causes of the recent wave of corporate failures.

A compensation system can, in effect, encourage hundreds or even thousands of employees at a company to fudge their results in ways that eventually can produce catastrophic losses, Black said.

Black refers in the written version of his testimony to “Atlas Shrugged,” a novel by Ayn Rand that is popular with company chief executive officers and describes what might happen if the most productive people went on strike.

“We, the citizens, need to go on strike,” Black says in the written version of his testimony. “The CEOs that caused this crisis are not Atlas holding up the world for us. We, the U.S. citizens, held up the world for them when their frauds caused the world to come crashing down. If they were to go on strike the world would be a far better place. They are the parasites.”

Copies of the witnesses’ written testimony and other hearing documents are available here.