American International Group (AIG) recently announced it was obligated to pay bonuses to its traders from its high-risk London unit sales totaling $165 million for the year. The announcement has sparked a wave of media-supported public outrage since AIG, one of the largest publicly-traded companies in the world and the world’s largest insurance corporation, is slated to receive $30 billion in government "bailout" assistance.

Obama Treasury Secretary Tim Geithner has responded by announcing a novel strategy for "justice." Geithner proposed that AIG "reimburse" the taxpayers up to $165 million for bonuses the company is giving employees. AIG will pay the treasury an amount equal to the bonuses and the treasury will deduct that amount from the $30 billion in government (taxpayer) assistance that will soon go to the company. But he said that the Obama administration hasn’t given up on efforts to recoup the money from the employees who got the bonuses. Good luck.

Congress followed Geithner’s lead and, on March 20, 2009, overwhelmingly passed (by a margin of 328-93) a quickly-assembled House bill to place a special 90 percent "income" tax on bonuses exceeding $125,000. While the bill was aimed at the highly-publicized bonuses paid to AIG executives, the tax would extend to bonuses paid to tens of thousands of employees at the nation’s nine largest institutions that have received at least $5 billion in assistance under the $700 billion financial rescue package Congress approved last year.

Obama’s National Economic Council Director Larry Summers is the man directly responsible for the current crisis. As Clinton Treasury Secretary from 1999 to January, 2001, he shaped and pushed the financial deregulation that unleashed the present crisis. He became treasury secretary after Robert Rubin left the post vacant in July, 1999, to become Vice Chairman of Citigroup, where he went on to advance the colossal agenda of deregulated finance directly.

As treasury secretary in 1999, Summers played a decisive role in pushing through the repeal of the Glass-Steagall Act of 1933 that was instituted to guard against just the kind of banking abuses taxpayers now are having to bail out.

In 2000, Summers also backed the Commodity Futures Modernization Act that allowed financial derivatives, including energy derivatives, to be traded "over the counter (OTC)" between financial institutions without government oversight.

Credit default swaps (CDS), at the center of the current storm, would not have been possible without Larry Summers and the Commodity Modernization Act of 2000. As the White House Economic Council director, he has been commissioned to find a solution to the crisis he helped make along with his friend Treasury Secretary Geithner.

This all makes great food for tabloid headlines and popular outrage. Paying $165 million in employee bonuses or any amount for a company that is in the middle of a multi-trillion dollar fraud that is bringing the world economy down with it is, indeed, "outrageous." The pundits can write that elected and appointed politicians are finally acting in taxpayer interests by firmly addressing the outrage and their responses seem reasonable enough until we look a bit more closely.

The problem is the Obama response to AIG bonuses is a misdirection ploy so the bailout hemorrhage can continue. The reason is the Obama administration, like its predecessor, refuses to take consequent action with AIG, despite the fact today the U.S. government owns at least 80 percent of AIG stock, bought with $180 billion in borrowed "bailout" funds. To demand AIG "pay back the government" is absurd as the government is, in effect, demanding it pay itself back. The latest claim that the treasury plans to subtract the $165 million bonus money from the next $30 billion "tranche" (multiple-class security) it will give AIG says it all.

The political "outrage" expressed by the Obama administration is an example of "perception management." The population is being slyly duped into believing their officials are working in their interest. In reality the officials are channeling growing popular outrage over endless bank bailouts away from the real problem to an entirely tertiary one. The U.S. government has injected $180 billion since September, 2008, to keep AIG in business and honoring its CDS obligations. In effect, they are propping up the casino to continue endless gambling with bailout dollars.

The rise of a market in derivatives or "swaps" contracts supposedly to "insure" against a company going into default and not being able to honor its debts, the CDS market is at the heart of the global financial catastrophe. The CDS market was "invented" in 1997 by JP MorganChase, which, interestingly enough, is one of the few big banks recording profit today.

As noted, CDS trading was created free from U.S. government regulation by President Clinton when he signed the Commodity Futures Modernization Act of 2000 which removed financial derivatives trading from government oversight. Enron crony, Union Bank of Switzerland bank adviser and former U.S. Senator Phil Gramm (R-TX) helped pass the laws at a time when his wife Wendy headed the putative regulator, the Commodity Futures Trading Corporation (CFTC). That gave the green light to a derivatives market nominally worth more than $62 trillion in 2008. No one knows the exact size because this is a "phantom banking market" that is completely private and confidential between banks.

Michael Greenberger, who headed the Trading and Markets division of the CFTC in the late 1990s at the time of the financial deregulation acts, said that banks and hedge funds "were betting the subprimes would pay off and they would not need the capital to support their bets."

The unregulated CDS market, he says, has been at "the heart of the subprime meltdown." In 1998 Greenberger proposed regulating the growing derivatives market. At the prospect of being regulated, he said, "all hell broke loose. The lobbyists for major commercial banks, investment banks and hedge funds went wild. They all wanted to be trading without the government looking over their shoulders."

The OTC confidence between banks collapsed after Lehman Brothers, the world’s fourth largest investment bank, declared bankruptcy. By then, there was no alternative but to nationalize and then sort out the mess. Bankruptcy, as the world now realizes, was not the answer to our financial problems. But former Treasury Secretary Henry Paulson’s TARP "casino rescue plan" is not the answer, either, nor is Geithner’s continuation of it going to solve our problems.

At the point the government let Lehman Bros. go down only months after "saving" the far smaller Bear Stearns and AIG (which isn’t even a bank), there was no clear idea which institutions would be saved and which would not. No bank could afford to trust any other bank because any of them could be holding "assets" of greater "toxicity" than their own. The crisis became a global systemic crisis. Notably, the man who participated in the decision to let Lehman Bros. fail, ostensibly to "teach a lesson," was then president of the New York Federal Reserve and current U.S. Treasury Secretary Geithner.

The U.S. government has stated that AIG cannot be allowed to fail. The reason the government says it can’t let AIG fail is that if the company defaulted, hundreds of billions of dollars worth of CDS would "blow up" which would cause U.S. and European banks, whose toxic assets are supposedly insured by AIG, to suddenly be sitting on immense losses. Quite the contrary, AIG is ‘too big to save’ under current rules of the game that have been written by Wall Street and the privately-owned Federal Reserve, Treasury Secretary Geithner’s former employer.

CDS purported, in theory, to let banks remove loan risk from their balance sheet onto others such as AIG, an insurer. It was based on a colossal fraud using flawed mathematical risk models.

AIG went big into the selling CDS with banks around the world from its London "Financial Practices" unit. AIG, in effect, issued pseudo "insurance" for the hundreds of billions of dollars in new Asset Backed Securities (ABS) that Wall Street firms and banks like Citigroup, Goldman Sachs, Deutsche Bank and Barclays were issuing, including sub-prime mortgage-backed securities.

It was a huge Ponzi scheme built by AIG that depended on the fact the world’s largest insurance company held a rare AAA credit rating from Moody’s and S&P rating agencies. That meant AIG could borrow more cheaply than other companies with lower ratings.

AIG issuing of CDS contracts acted as a form of insurance for the various exotic ABS being issued by Wall Street and London banks. AIG was saying that if, by some remote chance, those mortgage-backed securities suffered losses, AIG would pay the loss, not the banks.

Then it got really wild. Because credit-default swaps were not regulated, not even classed as a traditional insurance product, AIG didn’t have to set aside loss reserves. And it didn’t. So when housing prices started falling, and losses started piling up, it had no way to pay them off.

AIG then issued hundreds of billions of dollars worth of CDS instruments to allow banks to make their balance sheets look safer than they really were. Banks were able to get their loan risk low—not by owning safer assets—but by buying AIG’s CDS. The swaps meant that the risk of loss was transferred to AIG, making the bank portfolios look absolutely risk-free. That gave banks the legal illusion of meeting Bank for International Settlements’ minimum capital requirements, so they could increase their leverage and buy yet more "risk-free" assets.

How could that be allowed? The level of venal corruption in the Clinton and then Bush administrations rivals that of the last days of Rome before its fall from the internal rot of corruption. Banks invested $billions in lobbying Washington politicians to get their way.

Fortunately there is a simple way out of the AIG debacle. The U.S. government can step in and fully nationalize AIG, declare AIG’s CDS contracts null and void and let holders sue the U.S. government to regain value for what were, in reality, lottery gambles—not loans to the real economy. The U.S. government already owns 80 percent of AIG so the step to 100 percent is small. Doing that would end the global market in CDS and open the door for countless legal challenges. But AIG’s counterparties, as we begin to learn, were the big Wall Street players like Goldman Sachs, Citigroup and even Deutsche Bank. These banks have gotten enough in the form of bailouts to cover their risk in CDS. Let them realize the "risk" inherent with investment banking.

Myron Scholes, the "father" of financial derivatives who won a 1997 Nobel Prize in economics for inventing the stock options model that led to financial derivatives back in the 1970s, has declared that derivatives and CDS have gotten dangerously out of hand and says that derivatives traded over the counter should be shut down completely. Speaking at York University Stern School of Business recently, Scholes said, "[the] solution is really to blow up or burn" the over-the-counter market and start over. He included derivatives on stocks, interest rate swaps and credit default swaps that should then be moved into regulated markets.

The idea is simple and not that radical. A U.S. law banning OTC derivatives and moving them to regulated exchanges would end a colossal "shadow banking" fraud. Banks would not lose much more than they have already and the world financial system would get back to "normal." OTC derivatives are unregulated precisely to hide risk and enable fraud by the banks. It is past time to end that. This is where the U.S. Treasury and other governments must focus; not on meaningless regulatory "transparency" or trading bonus "justice."

F. William Engdahl is author of A Century of War: Anglo-American Oil Politics and the New World Order (Pluto Press) and Seeds of Destruction: The Hidden Agenda of Genetic Manipulation (www.globalresearch.ca) . His latest book, Full Spectrum Dominance: Totalitarian Democracy in the New World Order (Third Millennium Press) is due in late April. He may be reached via his website, www.engdahl.oilgeopolitics.net.