The American International Group bonus payment debacle could not have come at a worse time for a U.S. government that desperately needs to attract up to $2 trillion of private capital for its latest efforts to repair a crippled financial system.

Many big private investors see the public uproar over the ailing insurer's retention bonuses as significantly raising the risks associated with partnering with the U.S. Treasury in its proposed plan to buy toxic assets from ailing banks.

And investors are now also questioning whether the returns from investing in the Federal Reserve's and U.S. Treasury's new consumer debt and distressed asset facilities will be worth the hassle of intense public scrutiny, potentially onerous restrictions, and political criticism.

An irate U.S. Congress, fuming over AIG's bonus payments to executives after the insurer was bailed out three times using taxpayers money, are more likely than ever to change the rules of engagement -- possibly retroactively -- and that is unnerving money managers at hedge funds, private equity firms and banks on the eve of the long-delayed launch of the government's newest rescue efforts.

The government has changed the rules several times already and therefore there's a certain 'boy who cried wolf mentality' at this juncture on the part of investors relative to preliminary ideas that are generated by the government, said Jeffrey Gundlach, chief investment officer at Trust Company of the West with $110 billion in assets under management.

On Thursday, applications are due to participate in the Fed's and Treasury's $1 trillion program to revive consumer and small business lending -- known as the Term Asset-Backed Securities Loan Facility, or TALF.

The U.S. Treasury also this week is expected to reveal more details of a public-private partnership to buy up to $1 trillion in toxic assets from banks, freeing their balance sheets for increased lending.

The asset plan represents a critical test for Geithner, whose credibility was dented by personal tax issues during his confirmation and by widespread market disappointment with the lack of detail in his initial asset plan announcement in February.

And this week, Geithner's handling of the AIG situation was called into question when it emerged that he did not know about the bonuses when he arranged a $30 billion extension of AIG's bailout, then delayed notifying the White House for two days.

POLITICAL OUTRAGE

The political heat surrounding AIG, which agreed to the retention bonuses before the insurer's $173 billion government bailout was initiated last September, is adding another layer of anxiety on the part of hedge funds and other big money managers.

On Tuesday, outraged U.S. lawmakers proposed a special surtax on millions of dollars in executive bonuses at AIG amid howls of protest over the payouts. A House of Representatives hearing on the issue got underway on Wednesday.

What happens is that the Treasury and Fed design a reasonably good process or program, but politicians get involved and write onerous restrictions to legislation that results in private capital saying, This is far too difficult. Is this worth it?' said James Kochan, fixed-income strategist at Wells Fargo Funds Management, in Menomonee Falls, Wisconsin.

There is a risk that investors could pull out of these government programs, he added.

CHANGING RULES MID-GAME?

The government's plan to restart consumer and business lending or TALF was first announced in November last year and originally scheduled to start in February.

In a typical TALF deal, a fund would use $1 million of its own money combined with a $9 million loan from the Fed to buy a $10 million security. The security must be new and be triple-A rated and the Fed's loan is payable after three years.

The Fed and Treasury have made a number of concessions to issuers and investors to try to ensure the TALF program is successful, as it is seen as the central bank's premier program to boost consumer and business lending and the economy.

These include limiting auditors' ability to comb through investors' books and dropping executive compensation requirements for firms participating in TALF.

The Fed is desperate to attract new investors, such as hedge funds, to the asset-backed securities market in an effort to thaw consumer and small business lending markets. Before the crisis, ABS markets accounted for about 40 percent of all consumer lending.

But TALF also follows months of investor resentment over the other main government program for shoring up the banking system -- the Troubled Asset Relief Program or TARP.

Hedge funds and other big money managers including TCW's Gundlach have not shaken off the government's track record during the credit crisis of the past 18 months.

Look at the TARP -- $700 billion legislated for the expressed purpose of buying mortgage-backed securities, Gundlach said. How many dollars actually used by TARP to buy mortgage-backed securities? Zero! he said.

TARP was set up by the U.S. Treasury to buy toxic assets from banks but which ended up mostly being used to recapitalize banks with fresh equity.

Investors have seen the price chief executives have paid for taking government money.

Wells Fargo took $25 billion of capital last year from the government's TARP at the behest of regulators including then-Treasury Secretary Henry Paulson, but has said it did not need the money. It was one of nine original TARP recipients.

Monday, Wells' chairman Richard Kovacevich criticized the U.S. for retroactively adding curbs to TARP, which he said forced the bank to cut its dividend, and called the administration's plan for stress-testing banks asinine.

There's some concern that the government, being the government, can change the rules that they want, for example impose executive compensation restrictions ex-post, said Michael Feroli, economist at JPMorgan Chase in New York.

Similarly on inspection rights, and a lot of hedge funds get almost paranoid about their privacy.

Chris Low, chief economist at FTN Financial, added: You'd have to be crazy as a big investor to go into a partnership with the government right now, because as we've seen with TARP and AIG the government changes terms when they don't like how things work out.

(Reporting by Kristina Cooke and Jennifer Ablan, additional reporting by David Lawder and Megan Davies)

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