U.S. stocks dropped for the third straight day yesterday (Wednesday) on worries that increasingly rancorous debates will squelch a proposed $700 billion bailout of the U.S. financial system even as Federal Reserve Chairman Ben S. Bernanke warned Congressional leaders that the credit crisis was already damaging the American economy.As part of his most dire commentary about the U.S. economy since he became the central bank chief two years ago, Bernanke said the credit crisis posed “grave threats” to American financial stability and urged Congress to pass U.S. Treasury Secretary Henry M. Paulson’s $700 billion plan to excise devalued – and even worthless – assets from the banking system, Bloomberg News reported. Noting that “economic activity appears to have decelerated broadly,” Bernanke told members of the Senate’s Joint Economic Committee that “stabilization of our financial system is an essential precondition for economic recovery.”

Without the bailout, “credit will be restricted further for homeownership, for small business, for individual consumers and so on, but that is not just an inconvenience,” Bernanke said. “What that is going to do is affect spending and economic activity and it will cause the economy as a whole to decline and be much weaker than it otherwise would be.”

All three major U.S. stock indices declined – shrugging off earlier gains after investing icon Warren Buffett’s vote of confidence in Goldman Sachs Group Inc. (GS) prompted a rally – when investors realized there will likely be no quick passage of Paulson’s bailout plan. [A related report in today’s issue of Money Morning analyzes Warren Buffett’s investment in Goldman Sachs Group].

The blue-chip Dow Jones Industrial Average Index posted a loss of 161.52 points (-1.47%), closing at 10,854.17. The tech-laden Nasdaq Composite Index dropped 25.64 points (-1.18%), to 2,153.34. And the broader Standard & Poor’s 500 Index lost 18.87 points (-1.56%), to settle at 1,188.22.

“I think investors are sitting back and waiting to see what Congress does,” Fred Dickson, director of private client research and chief market strategist for DA Davidson, told TheStreet.com. “Hopefully, we’ll see something by the end of the week.”

While uncertainty over the outcome of the bailout plan remains, the market will trade with a great deal of volatility, Dickson added.

In other credit-crisis-related developments yesterday:

• Bernanke pleaded before the Senate’s Joint Economic Committee for Congress to act quickly, while U.S. Treasury Secretary Henry M. “Hank” Paulson relented on some of the taxpayer safeguards Congress sought to add to his original plan.

• President George Bush’s planned to address the nation last night as Republican Presidential hopeful John McCain proposed a halt to campaign activities to focus on the ongoing bailout debate in the Senate.

• And the Federal Bureau of Investigation (FBI) continued its ongoing investigation into some of the biggest corporate casualties of the current credit crisis.

Bernanke and Paulson’s Congressional Push

In his second day of Congressional testimony, the Fed chair appeared before the Joint Economic Committee to urge lawmakers to quickly pass the proposed legislation that would allow Paulson’s $700 billion bailout to take effect.

“Despite the efforts of the Federal Reserve, the Treasury and other agencies, global financial markets remain under extraordinary stress,” Bernanke said, predicting that the U.S. economy would likely contract even with the plan’s approval, the International Herald Tribune reported. But without it, he warned, the situation would be far worse.

“Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and our economy,” Bernanke said.

“With the exception of a few outliers on either side, there is clear recognition among members of both parties that we must act and act soon,” said U.S. Sen. Charles Schumer, D-NY, and the chairman of the Joint Economic Committee.

But without adequate safeguards, “then we risk the plan failing,” Schumer said.

According to The New York Times, Schumer said Congress must keep in mind the opinions of the constituents who have reacted with “amazement, astonishment and intense anger” at the bailout in its original form. Debate over the details continues as lawmakers argue for more provisions to safeguard the public interest.

Paulson has relented on executive compensation caps for companies that participate in the bailout, one of the most contentious amendments proposed by Congress, according to several media reports.

Meanwhile, Buffett endorsed Paulson’s plan in an interview yesterday morning on CNBC, saying it was “absolutely necessary” to stem an “economic Pearl Harbor.”

“The market could not have taken another week” like last week, Buffett told the news channel, Bloomberg News reported. “It was the last thing Hank Paulson wanted to do, but there’s no Plan B for this.”

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