WASHINGTON — The congressional response to the bonuses at American International Group Inc. is threatening the Treasury Department's ability to leverage private capital to take bad assets off banks' books.

Lawmakers rushed to pass a slew of bills last week that would retroactively apply conditions to some or all recipients of Troubled Asset Relief Program funds.

Now many investors fear the same could happen if they participate in the Treasury's as-yet-undetailed public-private partnership fund or the Federal Reserve Board's Term Asset-Backed Securities Loan Facility. If they do not participate, both efforts are likely to fail, observers said.

"It is impossible for me to fathom that when Congress talks about taxing bonuses at this level that it could be even remotely perceived as an encouraging indicator for why private capital would want to invest in anything when they might remotely be subject to congressional scrutiny before, during or after," said Doug Rediker, the director of global strategic finance initiatives at the New America Foundation.

Mark Zandi, the founder of Moody's Investor Services' economy.com, said investors are worried that any rules the Treasury adopts for its public-private partnerships, the details of which may be released this week, could later change.

"How do they know the rules aren't going to be different six months down the road, and they get creamed?" he said. "If you can go back and change preexisting contracts, what does it mean that I'm entering into a contract right now with you? It makes the whole thing a lot more difficult."

After news about the AIG bonuses last weekend, lawmakers moved at unprecedented speed. The House passed a bill taxing bonuses at 90% for all companies that received $5 billion or more of government aid a day after the House Judiciary Committee had targeted bonuses at any company that got more than $10 billion.

House Financial Services Committee Chairman Barney Frank, meanwhile, is pushing his own bill that would cover executive bonuses at any Tarp recipient.

The result was twofold, giving more impetus to bankers to return Tarp funds on the one hand and simultaneously undermining the credibility of the Treasury Department on the other. The Treasury, which orchestrated the four bailouts of AIG, was viewed by lawmakers and critics as complicit in letting AIG pay the bonuses.

Treasury Secretary Tim Geithner will get a chance to turn things around at a hearing Tuesday of Frank's House panel. He is expected to testify alongside Fed Chairman Ben Bernanke on the government's handling of AIG. The public-private partnership and the Fed's liquidity programs are both likely to be hot topics.

"The Treasury is just literally paralyzed by the politics right now," said Joseph Mason, a professor at Louisiana State University. "It's almost impossible for the Treasury to produce any credible policy that would make a change."

Observers said the Treasury would also probably need more money from Congress to create a workable public-private partnership fund — funds unlikely to be appropriated in the current political environment. The Obama budget calls for an additional $750 billion in funding, in addition to the $700 billion given to the Treasury last fall.

"This AIG fiasco has crystallized in their minds that it's not being used appropriately," Zandi said.

This leaves the Fed as the probable best bet to take illiquid assets off bank balance sheets, according to Gil Schwartz, a former lawyer at the central bank who now works in private practice.

"That's the only thing that hasn't been tried," he said, "and they've tried just about everything."

But whether the Fed's taking on the responsibility of buying bad assets would make for good policy is an open question. So far, its Talf program has been limited to newly originated auto, credit card, student and small-business loans.

Expanding it or creating a new program to finance the purchase of legacy assets on banks' books could dramatically increase the Fed's risk.

In addition to holding government securities, most of the assets on the Fed's balance sheet are highly rated — and observers said the situation should stay that way.

"The Fed has a fiduciary responsibility to keep their balance sheet clean," said Sung Won Sohn, a lecturer in business and economics at California State University Channel Islands. "The Fed must have a squeaky clean balance sheet because their reputation is very important. … No one is concerned about the Fed going bankrupt, but it's very important for the Fed to have a clean balance sheet so we know it's an institution we can trust."

Like the Treasury, however, the Fed's Talf plan is not immune from concerns that the government could later impose more conditions on companies that participate.

"Do they want to get in bed with the Fed managing assets?" said Bert Ely, an independent consultant in Alexandria, Va.

"You're going to have to figure out how to enter into a contractual relationship with the Fed to make sure Congress isn't going to be picking your pockets the next week."

The financial industry's reluctance to work with the government may already be on display. The Fed has promised to lend up to $1 trillion against securities backed by consumer loans.

But in the first round of lending, the Federal Reserve Bank of New York said last week that investors requested just $4.7 billion of funds.

If the Fed bought bad assets, its balance sheet could also lose luster quickly. Fed Chairman Bernanke and New York Fed President William Dudley have noted in recent weeks that the time will come when the central bank must slim down its balance sheet.

It could accomplish that by selling assets, but the Fed could face a conundrum if few buyers were willing to buy the toxic holdings.

"It can't shrink down its balance sheet if it's got the bad assets," Ely said. "It would have to hold less in the way of Treasuries."

Further complicating the Fed's prospects as an asset buyer are concerns that such activities could compromise its independence.

"This gives Congress yet another way to question what the Fed has done and whether they've done their job well," said Kevin Jacques, a former Bush Treasury official who is now the chairman in finance at Baldwin-Wallace College.

"It ratchets up the pressure on the Fed."

But observers agreed the government must find a way to remove bad assets from banks' books.

"There's still a definite need to get those assets off the balance sheets of the banks," Jacques said. "We've all seen already that the idea of injecting capital without getting bad assets obviously didn't work. If I've got these toxic assets, and I don't know how much they're worth, then I don't know how much capital I should be holding."

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