Challenge No 2: Fear and loathing in the banks

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By Janice Revell, Money Magazine senior writer

The Federal Reserve has slashed its target short-term interest rate down to zero (or darn close to it). That's as easy as easy money gets, and yet credit - the oxygen of any economy - is still scarce. UBS analyst Maury Harris estimates that tight lending standards will slice 3.25 percentage points off annualized economic growth in the first quarter of 2009. (In good times, the economy grows by about that much.) Banks are just plain scared to lend.

What to expect from Obama: The Obama administration will have a bunch of money to throw at the financial system when it moves into the White House Jan. 20. Just half of the $700 billion from the Troubled Asset Relief Program, or TARP, has been spent so far. Originally designed to save banks by buying up their toxic mortgage-backed assets, the TARP, true to its name, covers almost anything. It's now being tapped for the Detroit bailout, and Democrats in Congress want part of it to go toward preventing foreclosures as well.

Most of the money so far has actually gone to recapitalize banks - that is, the banks get money, and the government gets preferred shares in the banks. The idea is that this will encourage lending. But so far it seems that banks are hanging on to a lot of the money.

Congressional Democrats have argued that there should be more strings attached to this cash - and with an ideological soul mate in the Oval Office, they could get their wish. But the credit squeeze isn't just about cash-strapped banks. Investors are demanding huge yields - about five points over Treasuries - on investment-grade bonds, a disaster for companies looking for financing.

Much of what's happening now is really about confidence: Why lend when you see the economy headed for a deeper recession and there are still mortgages blowing up? In addition to pumping money into the financial system, Obama will have to do some first-class FDR-style confidence building.

Much of the power to get credit flowing isn't in Obama's hands, at least not directly. Although the Federal Reserve has run out of rate cuts, it's also been buying up mortgages, student loans, auto loans and credit-card debt. (The Fed is independent, but Obama can appoint a new chairman for 2010 and will fill some seats on the board.) It's put inflation fears on the back of the back burner. There's a risk: At some point the Fed will have to decide when to reverse this unprecedented easing. If its timing is wrong, inflation could be the next big problem, warns First Trust Advisors economist Brian Wesbury.

Your strategy as a borrower: If you have solid credit now, this is no time to let anything slip, not even a little. Double-check the due dates on all of your credit cards - they can change, and the window between when bills are sent out and the due date has been shrinking.

Your strategy as an investor: If you think Obama can turn the economy around, the credit squeeze has created some contrarian investment opportunities. Huge corporate bond yields may be bad for companies. But money manager Rob Arnott of Research Affiliates argues that the bonds are a bargain so long as this recession falls short of the Great Depression. Consider harvesting gains from Treasuries, which have appreciated as investors flee credit risk.

You may also want to hedge your inflation risk, in case the Fed overcorrects. Right now the market's not scared of inflation - falling prices are the concern du jour - so Treasury Inflation-Protected Securities, or TIPS, are historically cheap, yielding a real, after-inflation 2%.

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