NEW YORK (TheStreet) -- Hours after Lehman Brothers tumbled into history as the largest bank failure in U.S. history, Federal Reserve Chairman Ben Bernanke's concerns focused elsewhere.

Opening remarks on Sept. 16, 2008, according to transcripts released by the central bank on Friday, revealed that Bernanke and members of the Fed's policy-making wing -- the Federal Open Market Committee -- were uncertain how the Lehman bankruptcy would affect the broader economic system.

As part of regular procedure: the committee received a briefing on the latest economic and financial updates, which included the Lehman fall, and Bernanke then asked the presidents of the regional Federal Reserve banks to offer their latest assessments.

This is the story of what unfolded.

Liquidity Concerns

Bernanke started the meeting late, sometime after 8 a.m. Eastern time, and with his opening remarks said concerns were increasing about insurance giant American International Group (AIG) - Get American International Group, Inc. Report.

Then-Vice Chairman Timothy Geithner didn't attend the meeting that day because he was busy addressing the problems AIG faced and the risks the company posed to the financial system.

As the first order of duty, the manager of the System Open Market Account, William Dudley, recounted the latest economic changes. While Lehman received a bit of attention, Dudley detailed the reasons the Fed worried about AIG.

"The risk here, of course, is that, if AIG were to fail, money funds have even a broader exposure to them than to Lehman, and so breaking the buck on the money market funds is a real risk," Dudley said.

The key problem the Fed addressed throughout 2008 was keeping overnight funding between funds liquid. Any breakdown in liquidity on hand by banks in a single day could have quickly spread across the system and created a panic.

Starting in 2007, Bernanke realized many banks were having liquidity troubles and he wanted to guarantee that those banks avoided the problem. In an emergency meeting in 2007, he encouraged banks to use the Fed's discount window -- a short-term lending program. The problem, though, was that the discount window carried a stigma: if a bank was using the discount window, firms argued, then the bank must be in big trouble.

To mitigate this problem, the Fed in late 2007 opened up the Term Auction Facility, which allowed the central bank to auction off a predetermined amount of funds to depository institutions that used a variety of assets as collateral.

Little did they realize then that by September 2008 the largest banks by market capitalization would face the same crisis.

Dudley concluded the update by mentioning recent changes the Fed made to some of its lending programs.

Bernanke then asked Dudley to talk about swap lines offered to foreign central banks. Dudley said that Norway had just launched a facility to offer its banks U.S. dollar of up to $5 billion for one-week terms.

"The fact that Norway is doing this suggests that the situation has broadened quite a bit further because this is the first time that we have heard about Norway in this story, except for maybe some exposures to the Icelandic banks," Dudley said.

Fed members then discussed how broad the swap lines should be, and Dudley said it would be wise for it to be very large or open ended so as to provide a true backstop for the entire market.

"My point here is that, if foreign banks worry about capacity limits, even having a large program could in principle not be sufficient in extremis," Dudley said. "But if the program is open ended, the rollover risk problem goes away."

By a unanimous decision among the FOMC's voting members, the Fed consented to give the Foreign Currency Subcommittee the authority to enter into swap agreements with foreign central banks as needed.

The Fed Still Misunderstood How Deep the Recession Was

The Fed then turned its attention to a discussion of whether to raise the federal funds rate, which on that day sat at 2%.

Bernanke asked members to report the latest economic updates from their districts and to offer their vote on interest rates.

Atlanta Fed President Dennis Lockhart opened the discussion. Lockhart started by saying that the committee could not ignore the Lehman Brothers event that occurred during the weekend and the day before the meeting. He noted that it was too early to say that a bottom had formed in any of the housing markets.

Lockhart predicted that the federal funds rate target would remain around the current 2% level for "several months" going into 2009, and he recommended that the Fed not change the rate at that meeting.

Boston Fed President Eric Rosengren, whose comments pushed for the most accommodative monetary policy, offered a grim outlook. He didn't think that the problems accruing in the financial system were one-off events that only would hurt investment banks.

"The failure of a major investment bank, the forced merger of another, the largest thrift and insurer teetering, and the failure of Freddie and Fannie are likely to have a significant impact the real economy," Rosengren said. "Individuals and firms will become risk averse, with reluctance to consume or to invest"

Rosengren said he supported a 25 basis-point cut to the Fed funds rate -- the only member that day to outright recommend a cut.

In the aftermath of the financial crisis, critics have said the Fed took too long to cut rates near historic lows at zero. Supporters argue, as Bernanke even said in this meeting, that the central bank was setting monetary policy ad hoc during an unprecedented period in financial history.

Kansas City Fed President Thomas Hoenig encouraged the committee to resist the impulse to easy monetary policy just for the sake of doing something. But Hoenig and many of the members appeared to misjudge inflation pressures.

Leading into the financial crisis, energy and food prices were soaring, and the FOMC, rightly, showed concern to keep prices in check. However, oil prices started to break down in the latter part of 2008, as did food prices.

"We also have an inflation issue," said Hoenig, who, like most of his colleagues, didn't realize that the pullback in energy prices was part of an escalating trend that wouldn't soon reverse.

Repeatedly, FOMC members noted that inflation seemed to be dropping thanks to the fall in oil and gasoline prices, which added to their satisfaction of at least one worry they could drop. Still others feared that the committee couldnt rule out a spike in prices.

Philadelphia Fed President Charles Plosser's reasoning was that his concern stemmed from the fact that he didn't see the downturn as entirely demand driven. Minneapolis Fed President Gary Stern said: "But I will agree that it is still an open issue."

It's a concern that later would become irrelevant, to the point that in late 2009, core inflation according to the consumer price index reported declining prices -- a suggestion that deflation could be a threat. Even amid the Fed's unprecedented monetary stimulus programs since the Great Recession, inflation has proven to be of little concern in the immediate term.

Following Hoenig's comments, San Francisco Fed President Janet Yellen -- and current chairwoman of the Federal Reserve -- chimed in with anecdotal examples of economic headwinds.

"My contacts report that cutbacks in spending are widespread, especially for discretionary items. For example, East Bay plastic surgeons and dentists note that patients are deferring elective procedures," Yellen said. The room broke into laughter. She followed it with another amusing remark that the Silicon Valley Country Club, which used to have a seven-to-eight-year waiting list, witnessed the list shrink to just 13 would-be new members.

Yellen then said that the labor market was weakening, and that job cuts coupled with the housing and financial crisis "raises the potential for even worse news." The then-Fed president agreed with the majority that, at least for that meeting, they should not raise rates.

TheStreet Recommends

St. Louis Fed President James Bullard was the first to offer a long prediction of how the Lehman collapse could hit the economy.

"Concerning the national outlook, it is difficult and probably unwise to try to asses growth and inflation prospects in the immediate aftermath of an event like the Lehman bankruptcy. I expect to see more failures among financial firms, and I expect those failures to continue to contribute to market volatility," Bullard said. "This is part of an ongoing shakeout among financial market firms, following some of the worst risk management in a generation."

Plosser correctly assumed that the slowdown and turmoil in financial markets could turn out to be worse than he expected, yet Plosser said that didn't mean it was time "to panic and lower rates."

Chicago Fed President Charles Evans opened up with an offbeat comparison of the building financial crisis to the eve of the invasion of Iraq in March 2003.

Evans argued that risks to the economy may be too difficult for the Fed to characterize in its statements.

"Then, on the eve of the invasion of Iraq, the FOMC decided that geopolitical uncertainty was so great that the committee could not characterize the balance of risks at all in the policy statement," Evans said. "Today, the downside risks to output are almost too dispersed to characterize. In one or two weeks, we may know better that either the economy will somehow muddle through or we're likely to be facing the mother of all credit crunches."

Evans said it would be "quite an accomplishment" if the economy muddled through.

Cleveland Fed President Sandra Pianalto said she had a "small preference" for an option that would raise the Federal funds rate by 25 basis points, but she also said she didn't have a problem with leaving it unchanged.

Richmond Fed President Jeffrey Lacker said he thought Lehman's failure was a good thing, and that "it will enhance the credibility of any commitment that we make in the future to be willing to let an institution fail and to risk such disruption again."

After Lacker said he'd leave the funds rate unchanged, Bernanke asked the central banker a question about the role of fiscal intervention.

Bernanke, who is well-known as a Depression-era scholar, said history like what happened to Japan and Scandinavia showed that when a banking system becomes decapitalized and dysfunctional, government intervenes on a large scale.

"I'm seriously interested in knowing what you, or anyone else who would like to comment, think is the appropriate stage, if any, at which fiscal intervention becomes necessary," Bernanke said.

Lacker responded, "We have a legislated program of fiscal intervention -- deposit insurance -- and the boundaries around that are very clear."

Bernanke dropped the topic, but it seemed to foreshadow events that would lead to the Troubled Asset Relief Program, or TARP, that Congress passed to inject fiscal liquidity directly into the banking sector.

It was Dallas Fed President Richard Fisher, though, who delivered one of the most bizarre updates to the committee on Sept. 16. Fisher, who often pushes for tight monetary policy, provided a politician-stump-speech-like comment, invoking Bob Dylan, that urged the FOMC to unanimously vote to keep the federal funds rate unchanged.

"All of that reminds me -- forgive me for quoting Bob Dylan -- but money doesnt talk; it swears. When you swear, you get emotional. If you blaspheme, you lose control. I think the main thing we must do in this policy decision today is not to lose control, to show a steady hand," Fisher said. "I would recommend, Mr. Chairman, that we embrace unanimously -- and I think it's important for us to be unanimous at this moment -- alternative B. Thank you, Mr. Chairman."

Fisher said he believed there was mitigation of inflation, but still offered an unusual anecdotal example of price inflation at a Dallas bakery he'd been frequenting for 30 years, saying the establishment had just announced a price increase due to cost pressures.

Fisher's comments concluded with a coffee break announced by Bernanke. The Fed chief at the beginning of the meeting said they would cut the normally two-day event down to one.

When members returned, the first vice president of the New York Fed, Christine Cumming, who filled in for Geithner that day, noted that she didn't believe the recent ebb in inflation couldn't simply be explained by a decline in energy prices.

"We would attribute that to indications, again, that global demand is slowing," Cumming said. Her prediction was valid.

As we now know, the financial crisis in the United States spread to the European continent.

Throughout the meeting members contended that the housing crisis looked to be bottoming, but few of them offered a regional breakdown of housing sectors across the country, as Elizabeth Duke did.

The member of the Board of Governors of the Fed said that bottoms may have been reached in Ohio and coastal areas of California, but not everywhere.

"Florida is a bottomless hole -- speculation combined with insurance problems. In Arizona so much land was available that they can't find a bottom there," Duke said.

While on the mend, housing sectors in Florida and Arizona remain two of the biggest struggling areas in the country.

It's a Recession

Then it was time for Bernanke to step up.

The head of central bank delivered a gloomy outlook, and he was the only FOMC member the day after Lehman Brothers collapsed to say that the economy was in a recession.

"Personally, I see the prospects for economic growth in the foreseeable future as quite weak, notwithstanding the second quarter's strength," Bernanke said. "I think what we saw in the recent labor reports removes any real doubt that we are in a period that will be designated as an official NBER (National Bureau of Economic Research) recession."

Bernanke said the committee hadn't talked much about the fiscal side, which he called supportive, but feared would be less supportive moving ahead.

He agreed with members that there was a need for a well-developed structure to help avoid situations like the too-big-to-fail scenario unfolding, but Bernanke reminded them that events were happening quickly and "we don't have those things in place."

Ultimately, the FOMC agreed to leave interest rates unchanged, and they spent an extended amount of time determining the small changes in language to the statement.

The meeting after Lehman failed showed that central bankers, despite having witnessed Bear Stearns, Lehman Brothers and Merrill Lynch tumble and unemployment rates begin to surge, remained oblivious to how much further the crisis would deepen.

However, it also showed that some members, including Bernanke, were prepared for more surprises, and most appeared open to cut rates at any given moment.

And it was this openness to quickly cut rates that motivated the language of the finalized statement on Sept. 16, 2008: "The downside risks to growth and the upside risks to inflation are both of significant concern to the committee. The committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability."

Bernanke reminded everyone to be back on Oct. 28 and 29 and adjourned the meeting, unaware that he would call two emergency meetings before then in response to the darkest days of the financial crisis.

-- Written by Joe Deaux in New York.

>Contact by Email.

Follow @JoeDeaux