WASHINGTON (MarketWatch) -- Have we been had on this financial bailout? It's sure starting to look like it.

American International Group Inc.'s financial-products wizards, the supposed villains in bringing the world's largest insurance company to the brink of collapse, are literally laughing all the way to the bank. The disclosure over the weekend that they were getting $165 million in "retention" bonuses has inflamed public opinion. See the latest story.

Even worse, though, is the sad picture of the government flailing in the face of this outrage. It's hard to know which is more pathetic -- Treasury Secretary Timothy Geithner yelling ineffectually into the phone that these bonuses are unacceptable, or Federal Reserve Chairman Ben Bernanke slamming down the phone in anger at AIG AIG, -1.23% . Wow, that'll show 'em.

The colossal incompetence of the bailout that angered us when former Treasury Secretary Henry Paulson launched it has been continued and compounded in the current administration. It turns out that Treasury officials have known for months that these bonuses were going to be paid, and did nothing to stop it when they could.

“ Contracts are breached every day in the business world -- sometimes for no good reason, but sometimes for very good reasons. ”

No wonder. What started as a Paulson-Bernanke-Geithner plan continues virtually unchanged as a Geithner-Bernanke-Summers plan, and it hasn't become any more effective or better managed.

There seems to be little question that the government had to intervene to stave off financial collapse, but these recent events make it clear there has to be a better way.

If the stakes weren't so high, it would be almost comical. We need to retain the AIG wizards, we're told, because they're the only ones who understand how to undo the damage they've done. So it would have cost the taxpayers more than the $52 billion paid out to counterparties if they hadn't worked their magic?

And what about those counterparties? Heaven forbid that Goldman Sachs Group GS, -1.14% should lose a penny on its reckless credit default swaps -- that would mean the end of civilization as Paulson knows it. But that, thankfully, has been averted, as we also learned over the weekend, because that impoverished institution has received $13 billion of taxpayer money via AIG. I'm betting some of that money will find its way into Goldman bonuses as well.

The rescue of AIG has become a scandal of immense proportions. It is the signature debacle of a fundamentally flawed rescue plan that is being blindly pushed forward against all reason.

It threatens to sabotage not only any effective efforts to stabilize the financial system, but to define and derail a new administration that has an ambitious agenda of change. There is virtually no hope that Congress will approve any further funds for bank bailouts or economic stimulus, whether needed or not. The chances are rapidly diminishing that any of President Barack Obama's reforms will get a sympathetic hearing.

Blowback

In the end, the buck stops with Obama. For some reason, he appears to have a blind spot to the damage the mismanagement of this bailout is doing not only to any efforts to turn around the economy, but to his entire political agenda.

He continues unaccountably to rely on his economic team to handle the mess, while he goes about his business of doing the things he always wanted to do as president -- close Guantanamo, restore stem-cell research, invite Stevie Wonder to the White House. The result is that his credibility is suffering enormous damage.

“ Obama appears to have a blind spot to the damage the mismanagement of this bailout is doing not only to any efforts to turn around the economy, but to his entire political agenda. ”

The president delivered a tough-talk sound bite on Monday about pursuing every legal avenue to stop the bonuses, only to have his own advisers undercut his statement. "Gosh," they said, "there aren't really any legal avenues to pursue, sorry. But hey, we might withhold $165 million from the next $30 billion installment on the AIG rescue." That makes me feel better already.

The retention bonuses had to be paid, we are told, and have to be kept because of the "sanctity" of contracts. But contracts are breached every day in the business world -- sometimes for no good reason, but sometimes for very good reasons, such as fraud or malfeasance in delivery of the contracted good or service.

In those cases, the contractor refuses to pay. "So sue me" is as solid an American tradition as any other.

So let those AIG wizards sue for those retention bonuses. Does anyone really believe they would see it through the courts over a period of years and actually win damages that would cost more than $165 million?

In all likelihood, they would settle for something that is more reasonable for everybody concerned -- such as a performance bonus for the successful unwinding of the credit-default swaps.

Litigation of this sort is a tried and true part of negotiation, and the failure of nerve on the part of the government-appointed chief executive of AIG and the Fed and Treasury officials who approved payment of the bonuses has not served American taxpayers well.

So we're feeling had, because we have been had.