The U.S. Treasury Department missed a significant opportunity to head off public outrage over bonuses paid to employees of the foundering American International Group before the government invested $40 billion in bailout funds, the inspector general for the government’s Troubled Asset relief Program said in a report released Tuesday.

In addition, the Obama Administration’s “pay czar” has told AIG to scale back some $198 million in retention bonuses scheduled to be paid out to company employees in 2010.

The findings were part of the report by Special Inspector General Neil M. Barofsky, which detailed the government’s oversight of the AIG bailout. Barofsky criticized Treasury officials for conducting little due diligence into the company’s payment structure before authorizing the $40 billion bailout.

The report does confirm Treasury Secretary Timothy Geithner’s account that he had no knowledge of the bonuses scheduled to be paid to AIG executives prior to March 2009, three days before they were paid, but called that lack of knowledge a “failure of communication.”

“In light of the political sensitivities associated with the bailout of AIG, both as President of the (Federal Reserve Bank of New York) 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 so that he could have sufficient time to explore possible solutions,” the report said.

Barofsky recommended that Treasury conduct a full investigation of the compensation structure at any firm it planned to "take a substantial ownership position" in.

A spokeswoman for the treasury department did not return a call for comment on the report, but a response from the department included with the report said the department agreed with Barofsky's recommendations.

Barofsky also reported that only $16 million of a promised $45 million in retention bonuses paid to AIG executives last year has been repaid. Executives who received more than $100,000 voluntarily agreed to repay half of their bonuses in the wake of public and Congressional outrage over the payments, which totaled $168 million.
Tuesday, a spokesman for the company said they would work with “pay czar” Kenneth Feinberg on future compensation issues as well as repayment of the promised bonus money.

“AIG continues to discuss a variety of compensation issues with the Special Master, including future payments to employees of AIG Financial Products,” said spokeswoman Christina Pretto. “(AIG Financial Products) employees have until the end of the year to fulfill their commitments to return a portion of their March 2009 payment. We expect (Financial Products) employees will honor their commitments. In the meantime, those employees are making considerable progress in unwinding trades and reducing risk at (AIG Financial Products.)”

Outcry over the bonuses and others paid to employees of Merrill Lynch sparked a move in Congress to “claw back” money paid to employees of firms that received TARP funds. While no legislation requiring claw backs was ever passed, the Obama administration appointed Feinberg to review and approve compensation for the top paid employees at the seven firms that had not yet repaid the TARP money. 

In addition to AIG, the firms to be reviewed by Feinberg are Bank of America, (BAC)  Citigroup, (C) General Motors, GMAC Financial Services Inc., Chrysler LLC and Chrysler Financial.