American International Group Inc argued on Tuesday that a proposed $8.5 billion settlement between Bank of America Corp and investors in Countrywide Financial Corp mortgage-backed securities was not big enough.

The arguments came in the second day of a hearing before Justice Barbara Kapnick in New York state court on whether to approve the 2011 settlement.

Bank of America, which rescued Countrywide at the height of the financial crisis in 2008, agreed in 2011 to settle with investors who said Countrywide had misrepresented mortgages underlying its securities.

A lawyer for AIG, one of a handful of entities objecting to the deal, said the investors had first asked for $50 billion. "Why did that number crater from fifty billion dollars down to eight?" Daniel Reilly, of the law firm Reilly Pozner, asked in his opening arguments on Tuesday.

Reilly also said that Bank of America had a strategic relationship with BlackRock Inc , one of the investors that supports the deal, and with Bank of New York Mellon Corp , which is the trustee for 530 trusts holding the securities in question.

Reilly said Kapnick will have to consider whether the relationships are the reason "why the number craters" and why institutional investors never "seriously considered" a lawsuit against Bank of America. "This settlement amount is inadequate," he said.

Kathy Patrick, the lawyer who negotiated the settlement on behalf of 22 institutional investors, defended the deal in her opening statement, saying it was the largest in the history of private litigation and nearly twice the $4.8 billion that Countrywide was worth.

Patrick, of the law firm Gibbs & Bruns, represents BlackRock, MetLife Inc , Allianz SE's Pacific Investment Management Co (Pimco) and other investors.

Patrick said witnesses will testify that Bank of America Chief Risk Officer Terry Laughlin warned bondholders during negotiations that Bank of America could put Countrywide into bankruptcy, leaving investors with a smaller chance of recovery.

"Mr. Laughlin told investors at the outset that they had received clearance from the OCC to bankrupt Countrywide if that was what was necessary to protect Bank of America," attorney Patrick said. The Office of the Comptroller of the Currency is the regulator for national banks.

Kent Smith of Pimco will be the first witness in the case, testifying on Thursday after a recess on Wednesday.

Laughlin is expected to testify later in the proceeding.

A spokesman for Bank of America declined to comment on Tuesday.

Derek Loeser, a lawyer representing the Federal Home Loan Banks of Boston, Chicago and Indianapolis, which are also objecting to the settlement, said it did not provide enough money for the harm caused.

"The liability is so huge that it was one of the factors that brought down the economy," Loeser, of Keller Rohrback, told the judge in his opening.

Reilly, the lawyer for AIG, said the proceeding represented the last phase of the 2008 financial crisis.

"You are making a determination as to whether the banks are winners or the investors are," he told Kapnick.

On Monday, Matthew Ingber of law firm Mayer Brown, representing Bank of New York Mellon Corp, said in his opening statement that BNY Mellon agreed to the settlement because it was "a win for all investors."

Kapnick has set aside the first two weeks of June to hear the case, and it is then expected to resume in July. A ruling could take months after the proceeding is over.

The case is In re: Bank of New York Mellon, New York State Supreme Court, New York County No. 651786/2011.

(Reporting by Karen Freifeld; Editing by Eddie Evans and Stephen Coates)