Does the Fed set mortgage rates? In a word, no. Who then is responsible for setting mortgage rates? The truth is that mortgage interest rates are set by market forces, so the real question lies in looking at which factors most influence mortgage interest rates.
The Fed Funds Rate
First, let’s take a look at the Federal Reserve and how its policies affect mortgage rates. One of the responsibilities of the Federal Reserve is to set what is commonly called the Federal Funds Rate. This is the rate often referred to when people talk about the Fed cutting or raising “rates.” In reality, the Federal Reserve does not cut or lower “rates.” Instead, the Federal Reserve determines the Federal Funds Target Rate. This is the rate that banks charge when they lend money to other banks, usually overnight. Banks are required to meet reserve requirements, typically 10%. That means they must keep 10% of their funds on deposit with one of the Federal Reserve banks or as cash in their vault. If at the end of the day a particular bank has only 9.75% in reserves, that bank must borrow money to bring their reserve balance up to 10%. The quickest way to get that money is to borrow it from a fellow bank that has excess reserves. In short, the Fed Funds Rate is the rate that a particular bank will pay to borrow money from another bank for an overnight loan. A bank that consistently fails to meet reserve requirements will be shut down, so banks must borrow money to meet reserve requirements if their reserves are insufficient.
The Fed Funds Rate affects short term loans (usually overnight) between banks. As such, it does not have a direct affect on mortgage interest rates, which are long term financial instruments. Using common sense, the rate a bank pays to borrow money for one night will not directly affect the interest rate charged on a 30 year home loan. The Fed Funds rate is truly the shortest of short term interest rates. On the other end of the financial spectrum is the 30-year fixed rate mortgage, the longest of long term financial instruments. It’s easy to see why the two are not directly related. However, the Fed Funds Rate does have an affect on interest rates in general because it directly affects the prime rate, which is the base rate that banks charge when lending money. As you can imagine, if the banks pay more to borrow money, in turn, the banks are going to increase the interest rate they charge to customers. As such, the prime rate is tied to the Fed Funds Rate.
Even though the Fed Funds Rate does not affect mortgage interest rates directly, there is an indirect relationship. The Fed Funds Rate affects interest rates which, in turn, affect the financial markets. Anything that affects the financial markets is going to affect mortgage rates, so indirectly speaking, the Fed Funds Rate does have an effect on mortgage interest rates. When the Fed Funds Rate has been at historic lows, so have mortgage interest rates, for example. However, if the Fed drops the Fed Funds Rate, do not expect mortgage interest rates to drop because the two are not directly related.
Mortgage Backed Securities
Many people do not realize that mortgages are often sold almost as soon as they are originated. Here is how it works. You take out a mortgage with a well known home lender. That lender might retain the servicing on the loan (meaning they will still send you statements and answer your telephone calls), but they will often sell the mortgage itself. What they do is pool a group of mortgages and sell them to Wall Street. The people on Wall Street then sell those financial products (now labeled “mortgaged backed securities”) to investors. The people looking to buy mortgage backed securities are often pension funds, insurance companies and other institutional investors. Think of mortgages as the supply and the investors as the demand. Because the performance of the mortgage backed securities market represents demand, there is a direct relationship between the mortgage backed securities market and mortgage interest rates.
The 10-year Treasury
A 10-year Treasury Bond is an interest-bearing note issued by the United States Treasury. If you own a T-bill, the government owes you money. Because the Treasury bonds are backed by the “full faith and credit” of the United States, they are seen as low risk, making them a benchmark for other investments. Because mortgages rarely last longer than 10 years before being paid off, they are often compared to 10 year T-bills for investment purposes. While there is no specific or official relationship between the two, there is an unofficial trend between mortgages and t-bills. Here is how it works. Investors look at their options. Treasuries are 100% guaranteed to be repaid because the government can either raise taxes or print more money when the t-bill matures. Mortgage backed securities, however, are not a guaranteed investment. Some of the mortgages could default, for example, directly affecting the value of the mortgage backed security. Because the mortgage backed securities carry more risk, they do, of course, provide for a higher rate of return. To compensate for the added risk, mortgage rates must be priced higher than treasuries. The “spread” between mortgage rates and treasury rates widens and contracts based on investor appetite. The “spread” is an approximation of how much risk the market thinks there is. Essentially, mortgage bonds and t-bills compete for the same investment dollar, so there is a relationship between the two, although the relationship isn’t a fixed one.
In the end analysis, there are many factors that influence mortgage interest rates including supply, demand, inflation, and the economy in general. If the Fed Funds Rate is lowered tomorrow, it will have no more direct affect on mortgage interest rates than it will on the price of orange juice. However, the mortgage backed securities and treasuries markets are closely related to mortgage interest rates.
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