Treasury Secretary Timothy Geithner, while head of the New York Federal Reserve Bank, granted a waiver that allowed his eventual successor William Dudley to hold on to investments in firms getting emergency help.

Dudley, a former partner at Goldman Sachs who at the time ran the New York Fed's powerful markets desk, was allowed to maintain his financial stake in insurance giant AIG, whose government bailout helped prop up investment firms like Goldman Sachs.

Senator Bernie Sanders, an independent and a critic of the Fed's financial bailouts, called the finding from a Government Accountability Office audit released on Thursday disturbing.

The GAO recommended the Fed strengthen policies to prevent conflicts of interest, in particular in instances of emergency lending to non-bank institutions. Current policy focuses more narrowly on banks and bank holding companies.

(Three) days after the Federal Reserve Board authorized FRBNY (the Federal Reserve Bank of New York) to assist AIG -- the then-FRBNY President granted ... a waiver to a senior management official with financial interests in AIG and GE (General Electric) who was involved in decision making related to these two companies, the investigative agency said.

The New York Fed justified the waiver to Dudley on the grounds that he was critical to emergency operations, that the value of his investment in AIG was worth less than $15,000, and that divesting might violate laws on insider trading, according to the report.

William Dudley, who was then head of the Markets Group at the New York Fed, held shares in these companies as part of his personal portfolio that predated his service at the New York Fed, a New York Fed spokesperson said in reaction to the report.

The spokesperson said divestiture might have created the appearance of a conflict of interest. Dudley has since disposed of the shares.

The GAO said that of 12 staffers who volunteered potential conflicts of interest, the New York Fed ethics office required four to sell their stakes. The New York Fed declined a request to identify other staffers who received waivers.

The Treasury declined to comment on Geithner's role in granting the waivers.

The Fed's aggressive rescue efforts during the 2007-2009 financial crisis are viewed by many as having prevented an even deeper economic downturn. Officials were confronted with a fast-moving crisis that required quick responses.

The extraordinary efforts threw a spotlight on the central bank's power and raised questions about the close connections between the Fed and the financial institutions it oversees.

The GAO in its report also said the Fed should bolster policies for awarding contracts to carry out emergency activities.

The Fed awarded contracts worth $660 billion to private firms to carry out emergency efforts during the crisis, and eight out of the 10 highest-value contracts were awarded without a bidding process, the report said.

Many of the firms picked to run emergency programs were themselves getting Fed loans at rock bottom interest rates, Sanders said. Firms included JPMorgan Chase, Morgan Stanley, and Wells Fargo.

CRISIS DAYS

The disclosure comes as the GAO prepares another study on the governance of the regional Fed banks that, together with the Fed's Board of Governors in Washington, form the U.S. central bank system. That study is due out this fall.

Among the 12 regional Fed banks, the New York institution is first among peers because of its location on the doorstep of financial markets. Its president has a permanent vote on the Fed's interest rate-setting panel and it manages the Fed's all-important market operations.

The Fed was embarrassed in early 2009 when it became public that New York Fed Board Chairman Stephen Friedman, a member of the Goldman Sachs board, held a substantial amount of stock in that company when it was allowed to come under the Fed's protection during the crisis.

Friedman defended the holding, for which he received a waiver, but resigned from his position to spare the Fed the controversy.

Last year's Dodd-Frank financial reform legislation, which mandated the GAO study, made some changes to the powers of regional Fed board members, including taking away the right of some of them to vote for the regional presidents. The presidents participate in meetings of the Fed's influential policy committee and get to vote on interest rate decisions.

(Reporting by Pedro Nicolaci da Costa and Mark Felsenthal; editing by Andrew Hay and Leslie Adler)

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