The testimony from Paulson appeared to bolster some claims contained in a lawsuit brought by former AIG Chief Executive Hank Greenberg, who contends the terms of a government loan to AIG cheated its shareholders.
"AIG, either fairly or unfairly, ... became a symbol for all that is bad on Wall Street," Paulson said as he testified about the U.S. government's bailout of the insurance giant, which began with a $85 billion loan from the New York Federal Reserve in September 2008.
Paulson, who appeared relaxed as he testified in federal court in Washington, said he supported the loan as appropriate for the circumstances, especially because officials needed to send a message that any bailout would come with strings attached.
But he did not shed much light on how the terms of the loan were selected, which is at the heart of the case.
Paulson was one of the chief architects of the U.S. government's response to the unprecedented global credit crisis of 2007-2009, and he has since written a book about the experience. Monday's courtroom setting put Paulson on the hot seat in a way he has not experienced since Congress wrapped up its hearings on the subject years ago.
Legal experts have doubted the strength of the lawsuit, which is seeking as much as $50 billion from the government. The outcome of the lawsuit may affect how much flexibility regulators will have when they respond to future financial crises.
In the case of AIG, the Fed initially charged a high interest rate for the first loan and required a nearly 80 percent stake in the company in exchange, which Greenberg's lawyers have said was illegal.
While Paulson said he was not involved in setting the specific terms, he said the provisions were necessary to protect against "moral hazard," or concerns that other companies would take reckless risks under the belief that the government would bail them out with few consequences.
But in response to questions from a government lawyer, Paulson said Citigroup Inc's (>> Citigroup Inc) shareholders were not subject to similar terms when the bank also started to falter during the crisis.
Paulson said Citigroup was different, in part because policymakers were concerned about short sellers who were exerting pressure on Citi's stock and would profit if the rescue targeted Citi's shareholders.
Paulson said he was worried the traders would take the same strategy to the next bank, a concern he said he did not have about any of AIG's peers.
AIG's problems stemmed from insurance it wrote on $79 billion worth of shoddy mortgage securities; Citigroup and other banks facing mounting losses on toxic assets they held.
Paulson took the stand Monday morning wearing a dark suit and red tie, answering questions so directly that Greenberg's lawyer, star litigator David Boies, wrapped up what he expected to be six hours of testimony within a little over one hour.
The testimony by Paulson comes in the second week of what is expected to be a six-week trial. Former Treasury Secretary Timothy Geithner and former Federal Reserve Chairman Ben Bernanke are expected to testify later this week.
Boies has sought to portray the government as shutting down possible alternative rescues for AIG in 2008, including one from Chinese government investors. Paulson testified that such offers from China were unrealistic without a U.S. government backstop, which he said he had not been authorized to provide.
On Monday Paulson also said he had spoken in 2008 to then-presidential candidates John McCain and Barack Obama about the AIG bailout, and had informed them that AIG shareholders would be treated harshly. Paulson said he hoped that assurance would help convince the two candidates to avoid criticizing the deal in public.
Paulson, who served as President George W. Bush's Treasury secretary from 2006 to 2009, was previously the chief executive of Goldman Sachs Group Inc (>> Goldman Sachs Group Inc) and now runs an institute that focuses on climate change and other issues.
The case is Starr International Co v. U.S., U.S. Court of Federal Claims, No. 11-00779
(Reporting by Aruna Viswanatha; Editing by Steve Orlofsky)
By Aruna Viswanatha