Bailed-out insurance giant American International Group has slashed its exposure to credit derivatives by nearly two-thirds under government ownership, but a full recovery for taxpayers remains uncertain, a senior U.S. Treasury official said on Wednesday.

Jim Millstein, the Treasury's chief restructuring officer, told the Congressional Oversight Panel that the Treasury would seek to sell its stake as soon as practicable after AIG boosts its credit rating to single-A status.

Standard and Poor's rates AIG one notch lower at A-minus, with a negative outlook.

Millstein, in prepared testimony, said AIG's credit default swaps exposure was now down to $136 billion from about $400 billion -- with about $109 billion of the remaining exposure tied to transactions with European banks.

The Treasury Department holds about 80 percent of AIG's common equity as a result of government bailout actions in late 2008 and early 2009 as the company became unable to pay out insurance policies on investments tied to defaulting mortgages.

Treasury and Federal Reserve officials feared at the time an uncontrolled AIG bankruptcy would trigger a broad collapse of the global banking system. But the bailout spurred a virulent public backlash as it emerged in 2009 that executives of the failed firm were paid generous bonuses and that AIG's clients such as Wall Street giant Goldman Sachs were spared from losses in deals with the insurer.

Millstein told the oversight hearing that at current market prices, the Treasury's common equity stake in AIG has value that will inure to the taxpayers benefit. AIG shares were up 0.5 percent to $34.65 in Wednesday morning trade on the New York Stock Exchange.

But recovery on some $49.1 billion in preferred stock held by the Treasury is uncertain and largely dependent on the performance and market valuation of AIG's remaining businesses after asset sales.

While it remains unclear what the Treasury's ultimate recovery on its Series E and F preferred interests will be, it is clear that the prospects for the recovery on those interests have improved, and the government remains committed to protecting the value of these taxpayer investments, Millstein said.

FED TO GET PAID FIRST

In total, AIG is now operating with about $132.3 billion of financial support, including the Treasury stake and $83.2 billion in loans and interests in AIG investment vehicles from the New York Federal Reserve.

Millstein said proceeds from the agreed sales of AIG's two biggest international life insurance companies, AIA and ALICO, will be sufficient to pay off the New York Fed support.

The Fed's top lawyer at the hearing also pledged that the Fed loans would be repaid and defended the controversial bailout as necessary.

A loan from the Federal Reserve was the only mechanism available to the government to forestall a potentially catastrophic default by a systemically important financial company, Fed General Counsel Scott Alvarez said in testimony to the oversight panel.

New York Fed officials also defended their controversial decision to pay off credit default swap counterparties in full, saying they did not consider making emergency lending to AIG conditional on the giant insurer negotiating concessions.

The New York Fed came under harsh criticism this year for its decision to pay AIG's credit default swap counterparties, including Societe Generale, Goldman Sachs and Deutsche Bank AG, at par value. Some lawmakers accused the New York Fed of wasting billions in taxpayer money.

Conditioning our lending on AIG coercing certain creditors to agree to reduce the amounts due and owing from AIG would have been to ensure failure, Thomas Baxter, the New York Fed's general counsel, and Sarah Dahlgren, who led AIG rescue efforts at the New York Fed, said in testimony.

The tactic would have undercut our primary goal in providing AIG with necessary liquidity -- enabling AIG to pay creditors, maintain consumer, regulator, and counterparty confidence, and avoid default, they said.

(Additional reporting by Kristina Cooke in New York and Mark Felsenthal in Washington; Editing by Andrea Ricci)

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