As we digest the news that John McCain, who has missed more votes in Congress over the last two years than any other Senator, is suspending his campaign and wants to duck Friday’s debate, in order to offer his help crafting a bailout plan, now is as good a time as any to mull over what could be one of the first significant early tests for the next President. Who would Obama or McCain pick for the job of Treasury Secretary?

If the current crisis tells us anything, it is that the job of Treasury Secretary is of preeminent importance — especially if Congress grants Paulson anything like the discretionary fiscal power he is asking for. Whether you think Paulson is just another Wall Street fat cat grabbing goodies for his pals, or is actually motivated by a concern over the state of the economy, I think we should all be breathing a sigh of relief that neither of his predecessors, John Snow or Paul O’Neill, were in charge of grappling the current crisis. A recent New York Times story exploring possible choices for the job noted that O’Neill and Snow were two of “the least regarded Treasury secretaries of recent decades.” The Times was being polite.

My interest is not in handicapping who will get the job — the Times story does a good job of that, as does economist Menzie Chinn at Econbrowser earlier today. What interests me is that both the Wall Street Journal and the New York Times have speculated that Tim Geithner, President of the New York Federal Reserve Bank and a veteran of the Clinton Administration Treasury Department, is high on the list of likely Democratic prospects. Both papers observe that Geithner has been on the front lines of dealing with the current crisis.

But neither paper notes what to me is his greatest qualification — his early warning about the potential for exactly the kind of crisis we are currently enduring. On Sept. 15, 2006, Timothy Geithner gave a speech on hedge fund and derivatives regulation.

As I wrote at the time:

Geithner acknowledges that the explosion, over the past 10 years, of hedge fund trading in exotic financial instruments may well have contributed to the general resilience that the U.S. (and global) financial system has demonstrated in response to external shocks since the Asian financial crisis of the late ’90s. And yet he surmises at the same time that the very flexibility of the current system may actually make it more vulnerable to a really, really big shock.

Financial panics start when traders and bankers who call in loans or sell off their holdings at the first sign of trouble set off a cascading effect in which everybody else follows their example and the system implodes under the strain. Paradoxically, Geithner appeared to be saying, the more flexible the system, the more quickly such a cascade could happen, and the harder it could be to stop.

The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by and complicate the management of very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the large ones.

That’s a subtle argument, and we’re not going to know whether it holds water until the flood is already 5 feet high and rising.

Imagine, a man with the foresight to worry about how unregulated credit derivatives could increase the chances of systemic failure. Imagine having a President who might pick such a person as Treasury Secretary.

Or, conversely, imagine the surprises a John McCain could deliver. Maybe he’d pick a Robert Zoellick (a Goldman alum who is currently president of the World Bank) or a John Thain, (who just sold Merrill Lynch to the Bank of America.) Wall Street would likely not be upset at either choice. Or maybe he’d pick someone completely out of left field. As McCain demonstrates for us on daily basis, there’s really no telling what surprises are up his sleeve.

A reader asks: Where’s the evidence that a market collapse could cause a systemic meltdown inflicting widespread misery on millions of Americans? The answer lies in understanding exactly why investors are so nervous. Two words: credit risk.

On Wednesday morning, a metric lovingly referred to as “the TED spread” by financial whiz kids spiked dangerously high. The TED spread is the difference between the interest rate on three-month U.S. Treasury bills and three-month “LIBOR” — the interest rate that commercial banks charge each other for lending money in Europe. I can’t improve on Paul Krugman’s pithy explanation from March.

It’s a measure of financial jitters. If banks believe that their peers are solid, they should be willing to lend each other money on almost the same terms as money lent to Uncle Sam. When they start demanding a big interest rate premium, that’s a sign of fear.

So when the TED spread rises, the market fears banks are about to start failing. Last week the TED spread hit its highest mark since the stock market crash of October 1987. It subsided a bit after the news of the Paulson plan hit the markets, but it’s rising again now, as investors wait for new information on the prospects of the bailout.

So why should we all be worried? Well, for one thing, if banks start failing, and credit markets freeze up, then any business that depends on rolling over short-term debt to fund daily activities is in danger. Remember Enron? Enron imploded in a matter of days because its lenders suddenly refused to roll over its short-term debt. But it’s not just Wall Street investment banks and out-of-control Houston energy companies that depend on debt markets — a vast number of large corporations engage in the same practices. And if a significant percentage of large corporations can no longer borrow money the implications for the “real economy” will be substantial. Higher unemployment, slower or negative economic growth, etc.

And, of course, tight credit doesn’t just affect giant corporations that borrow a lot — it affects any small business or individual who needs a loan. Credit is the grease that keeps the modern economy going. Think about what happens to a car engine that runs out of oil. Hint: It doesn’t work anymore, and it costs an awful lot to fix.

The core truth of the modern economy is that all the big corporations, banks, hedge funds, insurance companies and countless other institutions are laced together by a web of debt, transmogrified in endlessly complicated ways by inscrutable financial derivatives. If one piece goes down, the ripple effects are expected to be dire. A credit freeze sets the stage for failures to begin. All of the Fed and Treasury interventions since last August 2007, when the credit markets first went haywire — and the TED spread started surging — can be seen as an effort to grease the economy, unfreeze credit markets, and increase liquidity. Because without liquidity, the whole system breaks down. There’s some pretty good evidence, assembled cogently by Megan McArdle right here, that suggests we came awfully close to such a breakdown last week.

Is the Paulson plan the best way to infuse liquidity back into financial markets and ensure that credit is readily available to everyone? I have no idea. Was the original plan an outrageous grab for power? Absolutely. Should Congress demand concessions that directly help homeowners and ensure taxpayers get a piece of the companies they are helping? I sure think so, although I also think I understand the counterargument. (Paul Krugman, incidentally, disagrees with me on that last point, although in a blog post today he called my argument “an interesting theory.”)

But the idea that there is a serious problem that must be addressed is not some kind of flim-flam attempt by the Bush administration to pull wool over our eyes. The TED spread doesn’t lie. Fear rules the financial markets today. And the longer nothing is done to address that fear, the worse it will get.

Ironically, the fact that President Bush is going to address the nation at 9 p.m. EST tonight to push for the bailout fills me with even more foreboding. Is there anyone this country trusts less than the current president? Let’s wait and see how his sage words move the TED spread.

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To a Wall Street desperate for good tidings, Warren Buffett’s $5 billion investment in Goldman-Sachs was interpreted as vote of confidence in the market. That’s why, the insta-conventional wisdom says, stock prices reversed their downward trend late Tuesday afternoon.

But it’s not so simple. If we know one thing about Buffett we know that he makes very good deals, and the Goldman Sachs investment is a very good deal, as Barry Ritholtz makes clear in his Big Picture analysis. Just for starters:

Goldman Sachs pays a fat dividend to Berkshire Hathaway of 10 percent on $5 Billion dollars — that’s $500 million per year. And, since this is a preferred, it gets paid out of net income in after tax dollars dollars. Ouch.

But even as news of the deal was filtering through the infosphere, Buffett said in an interview on CNBC that the current financial crisis should not be underestimated.

From Bloomberg:

Billionaire investor Warren Buffett, calling the market turmoil “an economic Pearl Harbor,” said Treasury Secretary Henry Paulson’s $700 billion proposal to prop up the U.S. financial system is “absolutely necessary.”

“The market could not have taken another week” like last week, Buffett told CNBC today, a day after saying his Berkshire Hathaway Inc. will buy a $5 billion stake in Goldman Sachs Group Inc. “I think it was the last thing Hank Paulson wanted to do, but there’s no Plan B for this.”

We would do well to pay attention. Judging by the comments on my last post last night, “Wall Street on Trial,” a substantial number of Salon readers subscribe to the “no bailout for Wall Street” camp. Let ‘em all burn! Death and destruction to Wall Street!

I understand the passion, but it seems to be based on the theory that markets could collapse and scores of Wall Street financial institutions could go bankrupt, and the rest of us would proceed merrily along, unscathed. But that’s just not how our economy works. If high finance implodes, markets collapse, and credit dries up, it’s not just people like Warren Buffett who will see massive declines in their net worth. We will all suffer. Unemployment will surge. Anyone who has any savings that are linked to stocks will be hammered. Retirement funds will be pummeled.

Warren Buffett was eerily prescient when he warned in his 2002 letter to Berkshire Hathaway stockholders that the explosion of derivatives trading posed huge dangers:

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

He could not have been more correct then. My bet is his current pessimism is still on the money.

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The senators, Republican and Democratic, who barraged Treasury Secretary Hank Paulson and Federal Reserve chairman Ben Bernanke with wave after wave of skeptical questions on Tuesday know full well that their constituents are royally pissed. A $700 billion bailout handed to the very people primarily responsible for making this mess — people who have fought against regulation and government interference in their business all their lives — makes for very bad politics. Americans are angry.

Smarter minds than mine have noted a key instance in which Ben Bernanke’s opening testimony deviated from his prepared statement. Both Paul Krugman and Felix Salmon seized on the following passage:

I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

First, banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down …

One of the most critical questions in evaluating the Paulson plan is figuring out exactly what price the government would pay for so-called toxic assets. Here Bernanke is explicitly stating that banks will not have to use “fire-sale prices.”

Krugman:

As I wrote earlier this morning, the whole “take these assets off the balance sheets” line is fundamentally disingenuous; the key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it’s going to pay above-market prices — prices that allegedly reflect “hold-to-maturity” value, but still more than private investors are willing to pay …

So the plan only helps the financial situation if Treasury pays prices well above market — that is, if it is in effect injecting capital into financial firms, at taxpayers’ expense.

What possible justification can there be for doing this without acquiring an equity stake?

Salmon:

Certainly under this system no outside investor would ever want to get involved. This is a bailout pure and simple, with the government paying too much money for banks’ assets. And I don’t like it at all.

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No wonder grass-roots Democrats like this guy:

Montana Sen. Jon Tester, to Paulson, Bernanke, SEC chairman Christopher Cox, and Federal Housing Finance Agency director James Lockhart:

I’m a dirt farmer. You guys have been in the business — the former chairman of Goldman Sachs.

Why do we have one week to determine $700 billion that has to be appropriated, or this country’s financial systems go down the pipes?

Wasn’t there some opportunity sometime down the line where we could have been informed of how serious this crisis was so we could take some preventative steps before this got to this point?

Perhaps back in the spring of 2007, say, when Paulson and Bernanke were telling us that the subprime problem was “contained”?