UPDATE 1-Records show Fed on edge during darkest days of 2008 crisis

Feb 21 (Reuters) - Federal Reserve policymakers, in an emotional meeting on one of the darkest days of the 2008 financial crisis, were worried the failure of Lehman Brothers a day earlier would wreak havoc on a teetering financial system but feared cutting already low interest rates might prove an over-reaction.

Transcripts of the U.S. central bank's meeting on Sept. 16 of that year, released on Friday, showed then Fed Chairman Ben Bernanke flatly telling his colleagues he was philosophically torn about the collapse of the investment bank.

They also threw fresh light on a debate over whether to loosen monetary policy in the face of a crisis that was fast engulfing financial markets but which some policymakers thought would be resolved relatively quickly.

Citing the moral hazard of making such "ad hoc" decisions over whether to help failing financial institutions, Bernanke weighed taking action "versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action."

"Frankly, I am decidedly confused and very muddled about this," he said at the meeting. "I think it is very difficult to make strong, bright lines given that we don't have a structure that has been well communicated and well established for how to deal with these conditions."

The central bank, which is still dealing with fallout from the crisis and the 2007-2009 recession, released transcripts of all 2008 meetings of its policy-setting Federal Open Market Committee (FOMC) on Friday after the typical five-year lag.

Looking back, the Fed was caught off guard by the severity of the crisis triggered by the subprime mortgage market. But, starting in 2008, it quickly took a series of unprecedented steps to reinforce the crumbling financial system and limit damage to the U.S. and world economies.

It was in 2008 that the Fed flooded financial markets with emergency liquidity, began printing what would be trillions of dollars in monetary stimulus, and made the first in a series of bold promises to keep policy loose.