Federal regulators cut a “loan sharky” interest rate on an $85 billion bailout loan to American International Group Inc. because it contributed to a debt service problem that threatened the insurer’s credit rating, the top lawyer for the Federal Reserve Bank of New York testified in a Washington federal court.

“We were part of the problem in setting that very high rate,” Thomas Baxter testified Friday.

Timothy Geithner, the head of the New York Fed at the time and the man who, according to Baxter, authorized that rate, will get a chance to explain his thinking this week when he takes the witness stand in the trial of a $25 billion illegal “takings” lawsuit by Maurice “Hank” Greenberg’s Starr International Co.

Geithner will be joined in court by two other men seen as the architects of the bailout loan as well as of the broader U.S. response to the 2008 financial crisis, former Treasury Secretary Henry Paulson and Ben Bernanke, the former chairman of the Federal Reserve.

The 12 percent interest rate, agreed to by AIG, which “in loose language I have referred to as a loan sharky rate,” was lowered after ratings agencies threatened a ratings downgrade in November 2008, two months after the bailout began, according to Baxter. He didn’t say how much the rate was reduced.

Starr, AIG’s largest shareholder at the time of the bailout, claims the government punished AIG by demanding equity and imposing an an interest rate on the loan of, in effect, 14 percent. The complaint alleges the U.S. didn’t have the legal authority to require equity as consideration for the loan.

Lawyers’ Testimony

Starr’s lawyer, David Boies, used the first week of trial to try to establish inconsistencies between what Baxter and an earlier witness, Scott Alvarez, the general counsel of the Fed, said in 2008 about government authority to take shares as part of a bailout and their in-court testimony about that power.

Boies presented Baxter with a summary of an interview in which he was quoted as saying, “We learned many things in September, and one was that we didn’t have the ability to own shares.”

Baxter told Boies he didn’t remember making the statement and “this is not consistent with my views.”

When Alvarez testified that he couldn’t say whether the government had the authority to purchase equity because “’purchase’ is too ambiguous a term, Boies pointed to a different answer Alvarez gave in a deposition.

Stock Transfer

In that earlier testimony, about the transfer of AIG preferred stock to the government for $500,000 shortly after the bailout began, Boies asked, ‘‘That stock was purchased on on September 22, 2008, correct?”

“Correct,” replied Alvarez.

“Now at that time you didn’t have any ambiguity about the word ’purchased’ did you,” Boies asked in court.

“So, I certainly didn’t state anything at the time,” Alvarez said.

Alvarez told the court that the authority to take stock in consideration for a bailout loan was embedded in a section of the Federal Reserve Act allowing a Reserve bank to extend credit in “unusual and exigent” circumstances.

In giving the authorization, the Fed “can set whatever limits and restrictions and rules the Federal Reserve Board believes is appropriate,” he testified.

In his testimony yesterday, Baxter said the November 2008 decision to lower AIG’s interest rate followed an internal debate over how that would play with critics of the bailout.

Fed ‘Pilloried’

“We were pilloried for doing this incredibly sweet deal for AIG. How will it look if we make it even better?” he said under questioning by Joshua Gardner, a Justice Department lawyer. “My response was we should do the right thing” and “make a very high rate lower.”

Stephen Aiello, a spokesman for Starr, criticized Baxter’s testimony about the public perception.

“This is an incredible statement when one compares the harsh, punitive terms of 79.9 percent equity and 14 percent interest dictated to AIG compared to the terms and treatment received by other financial institutions, specifically Goldman Sachs, Morgan Stanley, JPMorgan Chase and over 200 others,” Aiello said during a break in the trial.

Starr’s complaint alleges the U.S. wanted control of AIG to facilitate a “backdoor bailout” of the insurer’s bank trading partners.

Baxter testified “there was no interest on our part to be bailing out counterparties.”

Little Leverage

The New York Fed took over negotiations with the banks at the request of AIG and fully repaid them because it had little leverage to demand concessions, Baxter testified.

“If they were going to pay par out they didn’t need your help, correct?” asked Boies.

“I don’t know what was in their heads,” Baxter replied.

AIG initially kept the banks’ names secret because of a request by the insurer’s then-CEO Edward Liddy, who was concerned the counterparties would be stigmatized by their association with his troubled company, according to Baxter.

The counterparties also were protected from lawsuits from misrepresenting assets to AIG, Baxter testified.

Boies noted AIG has recovered hundreds of millions of dollars in litigation over banks’ misrepresentations. He asked whether the New York Fed considered settlements in which “counterparties would not get a release for fraud.”

“I have no knowledge of negotiations like that,” Baxter testified.

The case is being heard by U.S. Court of Federal Claims Judge Thomas Wheeler.

Wheeler has rebuked government attorneys for attempting to rely on hearsay testimony, introducing exhibits in violation of trial rules about redactions and dragging out proceedings by reading lengthy passages from documents.

The case is Starr International Co. v. U.S., 11-cv-00779, U.S. Court of Federal Claims (Washington).