The Goldman Sachs-AIG scandal may be worse than we think. Former New York Fed President and current Treasury Secretary Timothy Geithner is being castigated for paying off AIG's counterparties - Goldman foremost among them - 100 cents on the dollar and then keeping these payments secret. But it seems likely that Goldman actually got much more than 100%. What is worse, Goldman may have received this windfall by trading on information that was deliberately withheld from the public.

A brief recap of the Goldman-AIG story is necessary. Goldman has revealed that it had $20 billion in trades on with AIG, where it had bought protection on various toxic assets from AIG. Goldman believed this translated into $10 billion of risk to AIG, meaning that the mortgage assets might be worth as little as 50%. Against this $10 billion of AIG risk, Goldman had $7.5 billion in collateral from AIG. The rest of the risk, $2.5 billion, was hedged with Credit Default Swaps, whereby Goldman bought protection on AIG from a variety of highly rated banks. Goldman felt it was well-hedged, thus the repeated claim that it was not at risk if AIG defaulted.

The result of all this hedging was that a crisis at AIG would become a crisis at whatever banks Goldman had used to hedge its AIG exposure. Through its purchase of protection on toxic assets from AIG, and subsequent purchase of protection on AIG, Goldman created a situation whereby its risk to AIG became systemic risk.

Unfortunately for Goldman's critics, this is all fair play. If Goldman's purchase of AIG protection from other banks created a doomsday scenario, it was someone else's problem. Many on Wall Street have realized that being perfectly correlated with the end-of-the-world usually works out just fine.

Thus far in the story, none of the facts are really in dispute. One can criticize Goldman for creating a scenario where the only way it could fail was if the whole world imploded, but we might also commend the firm for its good risk management.

Therefore, the criticism of Geithner for "giving away the store" is overly harsh. Geithner had limited options. Through its swaps with AIG, Goldman had the power to start the chain of events that would destroy AIG. And through its hedges, GS had the power to ensure that this failure would reverberate through the rest of the banking system. It was a form of financial mutually assured destruction. Therefore Goldman's unyielding position was that it intended to collect from AIG 100% of what it was owed. Bet is to you, Mr. Geithner.

It is easy to hope that a New York Fed president would have had a bit more fortitude to play out the next turn of the cards. But we should not be surprised that Geithner blinked, folded, and paid the bill in full. The Fed's decision to keep these payments secret is less defensible.

If this were the end of the story, one would have no recourse but to grit and maybe buy stock in Goldman Sachs. But the story does not quite end there. The bigger story, still unexplored by regulators and Goldman's critics, concerns that $2.5 billion in protection Goldman had acquired before the crisis hit. What became of those hedges? What did Goldman Sachs do with its AIG protection?

Goldman spokesman Lucas van Praag made a disingenuous case in a letter to the Wall Street Journal last April. He implied that nothing much became of the hedges: "In order to collect under a credit default swap, there has to be an event of default. No event of default means no payout." Goldman would have us believe that since AIG did not default, the CDSs expired and vanished forever.

This is not quite right. A company can avoid default, but one can make a lot of money selling protection on the company when everybody else thinks they are going to default. That is especially true if one has been involved in meetings with the Fed where the subject of the meetings was how to avoid such a default. A good trader buys protection when a company seems very safe, and sells it when the company seems very risky. It is not appropriate for a trader to sell protection when he has non-public information that the risks have diminished, that the government has unequivocally committed to saving this company.

When did Goldman sell its $2.5 billion of AIG protection? Goldman representatives have said that the protection was sold in the six months following the September 15, 2008 bailout loan. This is problematic. That is so because the details of the bailout were not released until March 15 of last year, when the famous AIG counterparty payments at last became public.

This suggests that Goldman sold its protection to counterparties that knew materially less about the actual risk of AIG than Goldman did. Remember that this bailout was specifically designed to avoid an AIG default, the event that forces Credit Default Swaps to be triggered. Goldman, in frequent conversations with Paulson and Geithner, knew that the government had just committed $85 billion to avoid exactly this outcome.

The rest of the world, purposely kept in the dark, saw the risk of an AIG failure as imminent. In fact, on September 21, 2008 then-Treasury Secretary Paulson went on Meet the Press and explained that the $85 billion bailout loan would "allow the government to liquidate this company." Paulson may have been speaking loosely, but in the specific language of Credit Default Swaps a government "liquidation" is a Credit Event akin to bankruptcy and would "trigger" these swaps. This is why, immediately after the bailout was announced, the cost of protecting AIG risk skyrocketed. It rose to more than 40% of the amount hedged; meaning that Goldman, which had $2.5 billion in hedges, would have been sitting on over a $1 billion profit.

Not bad, even for Goldman. The government had just met their collateral calls, their risk to AIG was gone, and their hedges were in the money by $1 billion. What to do now? The right thing is to not sell the protection until the full details of the bailout are in the public domain. To wait until you have no material, non-public information.

It appears Goldman did not wait until after March to sell its protection. Yet Goldman has denied making a windfall gain on AIG. AIG CDS protection ended the second quarter of 2008 at about 200 basis points. From September 15, 2008 to March 15, 2009 AIG CDS never closed below 400 basis points. It is hard to see how Goldman could not have had a windfall. Depending on when Goldman sold this protection, the gain could have been as much as $1.5 billion. This would mean that while most of AIG's counterparties got 100 cents on the dollar, Goldman actually got far more.

Criticism of Geithner seems appropriate. Paying counterparties 100 cents on the dollar was unnecessary. Keeping the whole thing a secret was indefensible. Allowing windfall profits was unconscionable. But the Fed's behavior may not be the worst element of this episode.

Frankly, it is hard to see how, in having sold its AIG protection before March 2009, that Goldman Sachs can avoid the appearance that these trades were improper. Over a year on, we still await a clear explanation of how much the firm made from this protection and how its subsequent sale can be justified when Goldman had information that the federal government was deliberately keeping from the public.