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The Story of the Federal Reserve the Day After Lehman Brothers Collapsed

Tickers in this article: AIG BAC C JPM WFC

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 .

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.