WASHINGTON BUREAU – The American International Group Inc. bailout may have redefined the relationship between the federal government and the most sophisticated financial institutions, a watchdog agency warns.

The efforts of the Federal Reserve Bank of New York and the U.S. Treasury Department to rescue AIG, New York (NYSE:AIG), in late 2008 “distorted the marketplace by transforming highly risky derivatives bets into fully guaranteed payment obligations,” the Troubled Asset Relief Program Congressional Oversight Panel says in a new report on AIG.

“Throughout its rescue of AIG, the government failed to address perceived conflicts of interest,” and “the government’s rescue of AIG continues to have a poisonous effect on the marketplace,” the oversight panel says.

Federal regulators could have done more to try to arrange for a rescue funded at least partly by private parties, the panel says.

“Earlier and more aggressive efforts to protect taxpayers and maintain market discipline would, if successful, have had an enormous calming effect on the market – and even if ultimately unsuccessful, they would have strengthened the government’s credibility with taxpayers during a time of crisis,” the panel says.

“The importance of exhausting all options upfront is even greater given the government’s contention that, once the initial financial commitment was in place, any withdrawal of government support would have led to a catastrophic collapse of market confidence,” the panel says.

“Even at this late stage, it remains unclear whether taxpayers will ever be repaid in full” for helping to rescue AIG, the panel says.

The Congressional Budget Office is predicting that taxpayers will lose about $36 billion, the panel says.

“The uncertainty lies in whether AIG’s remaining business units are will able to generate sufficient new business to create the necessary shareholder value to repay taxpayers in full,” the panel says.

The panel acknowledges that the TARP program succeeded at achieving the goal of preventing an overall financial collapse.

“Nothing in this report takes away from that accomplishment,” the panel says.

The panel is supposed to keep fraud and abuse from occurring at TARP, a program the government created in late 2008 to help stabilize U.S. financial institutions.

Federal Reserve Board Chairman Ben Bernanke said Wednesday at a House Budget Committee hearing that he believes the federal government probably will break even or earn a profit on the money invested in AIG.

At this point, the direct cost of the government’s TARP investments in financial institutions is “not very large,” Bernanke said in response to a question from Rep. Lloyd Doggett, D-Texas.

“Except for AIG, every other major institution has repaid with interest and dividends,” Bernanke said.

Bernanke said he believes AIG also will repay the government.

“So, the financial institution part — the direct cost is, I think, really quite small and may, in the end, be in fact a profit,” he said.