Sept. 23 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the U.S. economy will shrink if markets don't begin functioning normally, joining Treasury Secretary Henry Paulson in urging skeptical lawmakers to quickly pass a $700 billion rescue for financial institutions.

``I believe if the credit markets are not functioning, that jobs will be lost, the unemployment rate will rise, more houses will be foreclosed upon, GDP will contract, that the economy will just not be able to recover,'' Bernanke told the Senate Banking Committee today. ``My interest is solely for the strength and recovery of the U.S. economy.''

Lawmakers have balked at rubber-stamping the Treasury plan to remove illiquid assets from the banking system, with Democrats demanding it include support for homeowners and limits on executive pay and Republicans resisting the plan's reach and size.

Bernanke, putting aside prepared remarks, signaled that the government should buy devalued assets at above-market values. ``If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits,'' he said.

The comments are the first indication by both Bernanke and Paulson about the price Treasury is willing to pay financial institutions for toxic assets. Growth in gross domestic product, or GDP, may slow to 1.5 percent next year, the slowest since the last recession in 2001 and its aftermath in 2002, according to the median of 80 economist forecasts compiled by Bloomberg.

Quarter-Point Cut

Federal funds futures traders have priced in a 66 percent chance of a quarter-point cut to 1.75 percent in the benchmark lending rate when U.S. central bankers meet Oct. 28-29, an increase from 34 percent yesterday.

The Fed and Treasury chiefs are trying to sway lawmakers such as Senator Sherrod Brown, a Democrat from Ohio, who said his constituents hold a ``universally negative'' opinion toward the proposal. Senator Jim Bunning, a Kentucky Republican, said the plan would ``take Wall Street's pain and spread it to the taxpayers.''

Republicans on the House Financial Services Committee intend to propose an alternative to the Paulson plan, Representative Spencer Bachus of Alabama, the senior Republican on the panel, told reporters today. He didn't describe the proposal. Bernanke and Paulson are scheduled to testify to the committee tomorrow.

`Clear Answer'

Senator Christopher Dodd, chairman of the banking committee and a Democrat from Connecticut, told reporters after the hearing he doesn't ``have a clear answer'' about whether the Paulson proposal will gain quick legislative approval.

The Bush administration ``needs to know, what they have sent us is not acceptable,'' he said. ``They're going to have to come back and work with us.''

Disruptions from the hearing room audience repeatedly prompted Dodd to call for order.

``No Blank Check,'' read a placard held up by one observer. ``Just remember, the fox is guarding the henhouse,'' yelled another person in the audience at the end of the almost five- hour hearing.

Bernanke pushed for the biggest federal intrusion into markets since the New Deal after failing to stem the credit crisis by cutting the benchmark interest rate at the most aggressive pace in two decades. The Fed has also pumped billions of dollars into banks to try and restore liquidity, and invoked extraordinary powers to loan to securities firms.

`Crisis At Hand'

``In light of the fast-moving developments in financial markets, it is essential to deal with the crisis at hand,'' Bernanke said. ``The Federal Reserve supports the Treasury's proposal to buy illiquid assets from financial institutions.''

Securities and Exchange Commission Chairman Christopher Cox and James Lockhart, director of the Federal Housing Finance Agency, also appeared before the committee.

Bernanke ``is concerned that if this stays in limbo for a long period, the markets will say Congress is not serious and is not addressing the problem,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina, and a former senior economist for the banking committee.

Paulson said that ``we must now take further, decisive action to fundamentally and comprehensively address the root cause of this turmoil.''

A bailout should follow three principles: protection of taxpayers; proper oversight, transparency and accountability; and aid to homeowners to stem foreclosures. Blame for the crisis lies with ``private greed and public regulatory neglect,'' Dodd said.

`Massive Amount'

Senator Richard Shelby of Alabama, the panel's senior Republican, said Congress probably can't ``solve this crisis by spending a massive amount of money on bad securities.'' He called for ``a comprehensive and workable plan for resolving this crisis before we waste $700 billion of taxpayer money.''

One option may be to authorize the $700 billion in installments such as $150 billion at a time, Democratic Senator Charles Schumer of New York said. ``Significant modifications'' to the Paulson plan ``are necessary,'' he said in a statement after the hearing.

Bernanke said, in order to avoid disrupting markets, the Treasury shouldn't buy assets at a deep discount. He urged Congress to avoid specifying the purchase terms or mechanism in the legislation.

``I believe that under the Treasury program, auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets,'' he said.

`Necessary And Appropriate'

The decision by the Treasury this month to put Fannie Mae and Freddie Mac into federal conservatorship was ``necessary and appropriate,'' Bernanke said in a review of government interventions in financial markets this month.

Lockhart, asked about how long Fannie Mae and Freddie Mac will be in that state, said it will depend on how long it takes the housing market to stabilize, which may take a year or longer.

Central bankers looked for private-sector solutions to avoid the collapse of Lehman Brothers Holdings Inc. and a potential failure of American International Group Inc., Bernanke said. The Fed chairman said a collapse of AIG would have ``severely threatened global financial stability'' and U.S. growth.

The Fed Board authorized the New York Fed this month to lend up to $85 billion to help AIG pay its creditors. The Fed ensured the loan involved ``significant costs'' to the firm to avoid the perception the central bank would continue bailouts.

`Posed Risks'

Lehman Brothers also ``posed risks,'' Bernanke said. ``But the troubles at Lehman had been well known for some time'' and Fed officials judged that investors and counterparties ``had time to take precautionary measures.''

Still, Lehman's bankruptcy and AIG's troubles contributed to the ``extraordinarily turbulent conditions in financial markets,'' Bernanke said.

U.S. stocks fell for a second day on concern Congress will hold up the bailout package, with the Standard & Poor's 500 Index declining 1.6 percent.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net.

Last Updated: September 23, 2008 17:00 EDT