The Government withdrew the $12.5 million loan offer on Tuesday after the polytechnic would not agree to a loan condition that a Crown manager be appointed to oversee its financial transactions.
At the first council meeting since the decision, Mr Crombie said yesterday it had been a "very disappointing week" for staff who had worked on the project.
"This isn't the outcome they deserved".
However, he said the institute - a joint venture between the polytechnic and the University of Otago - would continue to operate from several sites.
Council member Rebecca Parata, who is also community services team leader for the Dunedin City Council, said the public support for the institute was strong.
"A lot of people who are against the [new Otago] stadium are for the institute," added Chris Staynes, also a Dunedin city councillor.
Malcolm Macpherson, who is also Central Otago Mayor and a member of the Otago Forward economic development board, said the board was "not at all downhearted" the loan had not come through.
"Otago Forward is still 100% behind the design institute concept and will do what it can to support version two" - the institute without a central building or base.
Council deputy chairman Mark Ryan said the loan condition did not recognise the hard work which had been put in by the council and staff to reposition the polytechnic after several years of financial difficulties.
"That is a great pity".
On Wednesday, the Otago Daily Times put a series of questions in writing to Tertiary Education Commission chief executive Roy Sharp about the loan and the dispute over the level of Crown involvement tagged to its approval.
Yesterday, TEC tertiary network director David Nicholson said it did not intend to make any comments on loan applications by any tertiary institution.
