Washington–New York Insurance Superintendent Eric Dinallo came under withering fire from the leadership of the Senate Banking Committee today as he tried to defend state regulators’ role in overseeing troubled American International Group.

Dinallo came under the microscope as panel members sought to determine why the federal government has been forced to pony up $170 billion so far to stabilize AIG–and whether the Treasury Department and the Federal Reserve Board know how much more will be needed to keep AIG afloat.

In his opening statement, Sen. Chris Dodd, D-Conn., chairman of the committee, said the debacle at AIG is “quite frankly, sickening.”

He added that “The lack of transparency and accountability in this process has been rather stunning.”

Federal Reserve vice Chairman Donald Kohn defended the actions of the Fed and the Treasury in the 4 successive bailouts of AIG, saying, “No one was minding the whole company and looking at how things interacted, and whether the whole company would, under some circumstances, put the financial system at risk.

The strongest comments came from Sen. Jim Bunning, R-Ky., who called AIG a “lost cause” and ridiculed the regulators, especially the Treasury Department and the Federal Reserve Board, for not knowing exactly how much it is going to cost to stabilize the company.

Donald Kohn, vice chairman of the board of governors of the Federal Reserve System, and Scott Polakoff, acting director of the Office of Thrift Supervision, were also criticized for their roles in regulating the company.

In acknowledging its role in the AIG debacle, Polakoff said OTS fell short in failing to recognize in time the extent of the liquidity risk to AIG of certain credit default swaps held in the portfolio of the company’s financial products division.

OTS oversaw the holding company where AIG Financial Products, which engaged in the credit default business, operated.

It was the need to provide counterparties with more cash as AIG’s credit ratings fell that prompted the original U.S. government bailout last September.

Commissioner Dinallo was criticized mainly because of AIG’s securities lending program, a program that resulted in a $21 billion loss by the firm’s life insurance subsidiaries in 2008. The Fed created a mechanism in December that took AIG off the hook for the securities lending program conducted through use of life insurance company assets.

But Commissioner Dinallo was resolute in defending state regulation.

In his written testimony, he said AIG’s problems did not stem from its state regulated insurance companies.

“The primary source of the problem was AIG Financial Products, which had written credit default swaps, derivatives and futures with a notional amount of about $2.7 trillion, including about $440 billion of credit default swaps,” he said.

He contended that the main reason why the federal government decided to rescue AIG was not because of its insurance companies. Rather, the problems were caused by the systemic risk created by AIG’s Financial Products unit, based in London, he said.

At the same time, Dinallo acknowledged that, before late 2007, his agency had not monitored AIG’s securities lending program through its life units “as good as it should have been.”

But Sen. Richard Shelby, R-Ala., ranking minority member, criticized Commissioner Dinallo’s defense of state regulators, 5 of whom were involved in the securities lending program. “Your testimony is ambiguous,” he said.

Shelby said that the National Association of Insurance Commissioners has stated that, a life insurance company may participate in securities lending only after it obtains the approval of its state insurance regulator.

“If so,” he asked, “why did state securities regulators allow AIG to invest such a high percentage of the collateral from its securities lending program in longer-term mortgage-backed securities lending, since involved life insurers were regulated by at least 5 states?”