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Robert F. Bukaty  /  AP
Mortgage rates hit record lows in March this year helped by government help to lenders. A big question is what will happend when that help goes away.
updated 9/17/2009 5:58:46 PM ET 2009-09-17T21:58:46

It's a good time to borrow money for a home, car or small business.

A year after a global freeze in the credit markets prompted massive government intervention to prevent the financial system from collapsing, interest rates remain at historic lows. But banks are demanding more collateral, bigger down payments and detailed financial histories from borrowers.

And that's for people with good credit. Everyone else need not apply.

The stingy lending is likely to last.

"Banks are going to be in a defensive posture for several years. Most borrowers can't meet their criteria," says Christopher Whalen, managing director at research firm Institutional Risk Analytics.

No segment of borrowers has been spared:

  • Nearly seven of 10 mortgage applications were approved and financed during the housing boom five years ago. At the end of 2008, the number was down to five.
  • Revolving credit, which is primarily made up of credit card debt, declined by $6.1 billion, or 8 percent on an annualized basis, in July. That's a sign consumers are having difficulty obtaining credit and are cutting back on spending.

To be sure, it is cheaper for businesses and consumers to take out a loan today than it was at the height of the crisis last fall.

The average 30-year mortgage rate stands at 5.04 percent, after falling to a record low of 4.78 percent in April. The overnight rate that banks charge each other to borrow money — a key indicator of the credit markets' overall health — has plummeted. The London Interbank Offered Rate, or LIBOR, stands at 0.29 percent today. It soared above 6 percent last September when fear threatened to choke off lending throughout the financial system.

But those improvements are somewhat misleading. Lending — especially for homes — is being greased by trillions of dollars the federal government has made available to banks.

The Federal Reserve has provided nearly $340 billion in low-cost loans for banks. It has purchased $625 billion worth of mortgage-backed securities to drive down interest rates on home loans. The Federal Deposit Insurance Corp. is guaranteeing about $300 billion in bank debt, which enables banks to borrow at lower rates.

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No one wants to see a return to the easy credit that led to the financial crisis. The question is when will credit return to normal — not too loose, not too tight and not propped up by the government?

Not soon, financial analysts and government officials say.

"We will not make the mistake of prematurely declaring victory or prematurely withdrawing public support for the flow of credit," says Lawrence Summers, the White House's top economic adviser.

Some analysts think it could take four or five years for the Fed to withdraw the money entirely and shrink a balance sheet that is now about $2 trillion, more than double what it was when the financial crisis struck.

The government's role in steadying the housing market is huge. Home sales are rising, but more than two-thirds of U.S. mortgages made in the first half of this year were later sold to Fannie Mae and Freddie Mac, which are 80 percent owned by the federal government. Three years ago, Fannie and Freddie's combined share was 33 percent, according to Inside Mortgage Finance, a trade publication.

Some financial analysts fear what will happen as the government winds down its lending programs. These analysts say banks have become so hooked on federal aid that they may become even more reluctant to lend once it is gone.

The mortgage industry is particularly worried. It has been pressuring the government to extend an $8,000 tax credit for first-time home buyers, fearing a recent increase in homes sales could prove fleeting without the tax break. The White House said Wednesday that it's considering extending the tax credit, which is scheduled to expire in November.

"It's the No. 1 question in the market: Can we wean ourselves off our addiction to cheap government-supplied credit?" says Mitch Stapley, chief fixed income officer at Fifth Third Asset Management in Grand Rapids, Mich.

If not, the nascent economic recovery could be cut short. Weak lending and borrowing would limit corporate and consumer spending, which accounts for 70 percent of economic activity.

The incentives are especially important these days, lenders say, because the habits of borrowers have changed.

In a sign that the recession and rising unemployment have made people leery about taking on more debt, the national savings rate was 4.2 percent in July. It dipped to a low of 0.8 percent in April 2008.

Big banks are not risk averse. Rather, their reluctance to lend reflects the fact that they must conserve cash to absorb billions in losses still expected to occur from bad loans that were made before the crisis. FDIC-insured banks cumulatively lost $3.7 billion in the second quarter, dragged down by growing numbers of bad loans. These banks set aside nearly $67 billion in the quarter in anticipation of future losses from soured loans.

Another factor sapping their appetite for lending is their diminished ability to pool loans into securities for sale to investors, a process known as securitization. This secondary market allows banks to reap fees when they sell the securities, as well as get cash to make more loans.

At its zenith, the securitization market funded $9 trillion in loans. The collapse of Lehman Brothers led panicked investors to pull their money out of the marketplace virtually overnight, wrecking the securitization business.

"The assembly line for loans is broken," says Whalen of Institutional Risk Analytics.

Federal Reserve Chairman Ben Bernanke predicted this week the market "will come back" but probably not at the size it was.

For consumers, that's made qualifying for credit a challenge.

Germaine Code, of Grand Rapids, Mich., was turned down last month for a mortgage on a $135,000, three-bedroom home because of delinquencies dating back more than 10 years that he says should have been removed from his credit history.

"The bank said my credit score was good but that I needed to get those (delinquencies) taken off and that my wife needed more time in her job," says Code, who was able to get a lease-to-own option on the house.

During the boom years, home buyers needed a credit score of 660 or above to qualify for the cheapest interest rates, says Greg McBride, senior financial analyst at BankRate.com. Today, they need a score of 740 or above.

Home lenders are also demanding proof of income and down payments of at least 20 percent. Before the bust, first-time home buyers often got mortgages with no money down and without proving they could afford payments.

The tough climate has forced many would-be borrowers to give up.

Consumers ratcheted back borrowing by $21.6 billion from June to July, the biggest drop since the Federal Reserve began keeping records in 1943. That left consumer debt at $2.47 trillion — slightly less than where it stood at the height of the crisis.

"Lots of people are fearful for their jobs. Even if you have good income, you're probably cutting back on borrowing," says longtime banking analyst Bert Ely.

The drop in borrowing could slow the economy's recovery. That's why it's critical for the government to continue stimulating lending, especially in the crucial housing market, says David Olson, president of Access Mortgage Research & Consulting.

"If they cut back it would be catastrophic," Olson says. "We could have a second downturn."

Copyright 2009 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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