I'm not sure where to post this - siding, insulation, walls...so I'm going to hit a few boards and see what I can get.

We are renovating a 1935 craftsman/four-square inspired house. The house was updated at some point (likely the fire it had in the 80s or 90s) as all but one room now has sheetrock rather than plaster. The house has wood siding that has been covered with aluminum siding. There is a layer of foil-backed sheet insulation between the wood siding and aluminum siding. We've been removing the aluminum siding to get back to the wood siding (in great condition, by the way) - have about half of the house done. However, while doing some interior work we removed some sheetrock and found ourselves looking at batt insulation and the inside of the wood siding. We expected to see diagonal 1x wood sheathing like our subflooring.

Now we're concerned that the foil-backed sheet insulation was acting as a vapor barrier, and we're worried about water intrusion into the wall cavity, as the wood siding is nailed directly to the studs. Is this a valid concern? We plan to repair/replace any wood siding as necessary. Is it just a matter of caulking the he!! out of any joints or should we consider removing all of the sheetrock and doing some sort of treatment inside the wall cavity and replace with mold-resistant sheetrock? Any other thoughts? Much appreciated!