It's no secret that the housing and mortgage market is a giant weight around the neck of the US economy, which is now in recession. In order for the markets to stabilize, housing has to pick up, or at least stabilize to some degree. Lest we forget, the economic boom of the last 5 years was largely driven by the housing and credit markets. Now they are like a European luxury car that looked amazing rolling off the lot and drove well for a couple years, but now things are falling apart, repairs cost a fortune ($700 billion) and we can't get rid of it because nobody will buy it.

But lower rates offered hope, right? And today the Federal Reserve voted to reduce the Fed Funds Rate to nearly zero. I heard an ad on the radio this morning from a mortgage company claiming the Fed is "lowering mortgage rates." This simply isn't true.

The Federal Reserve does not set mortgage rates

It's a common misconception that mortgage rates are directly tied to the Fed Funds rate. The two are related, but not directly tied. Another common misconception is that they are directly tied to bond rates. This, again, is not quite true.

There are three separate supply and demand markets that impact the rates banks extend.

The Housing Market

This is the market most people participate in at one level or another. Land is developed, people buy new homes, and people buy the homes of those people.

When this market is strong, rates tend to rise as demand increases. But not always. Rates are also impacted by other factors in the markets explained below.

The Secondary Market

Once you have taken out a loan with a mortgage broker or bank or other lender, the loan is usually sold off on the secondary market. Players like Fannie Mae, Freddie Mac (they sound like star-crossed lovers from a Tennessee Williams play) and Citigroup will buy yours and your neighbor's mortgage loans from the banks and brokers. And since Uncle Sam took the reigns at Fannie and Freddie, it's now the Federal Government buying them.

The Investor Market

When the secondary market buys loans, they turn them into securities or funds which large institutional investors then invest in. These so-called "mortgage-backed securities" used to be a conservative alternative to traditional stocks.

When the equity markets are performing well, they create competition against mortgage backed securities and funds. Investors are always looking for the highest yield (return) possible, so when other options are available, they tell mortgage buyers Fannie and Freddie that unless they offer some higher-yield options, they are moving to bonds or stocks. So those mortgage buyers then require higher yield loans from the issuing banks and lenders (those who originally sold you the loan) and rates rise.

Conversely, when the market expects the Fed to lower rates, they start snatching up bonds quickly while higher interest rates are still available. That drives up demand and allows banks to lower rates. And if the stock market is performing poorly, investors look for mortgage backed investments as an alternative, again, pushing mortgage rates down.

What's happening now?

This is what should be happening now, right? The equities markets are uncertain and volatile, and the Fed continues to lower rates, driving up present demand for bonds and mortgage backed investments, thus pushing mortgage rates lower.

But it isn't happening the way it should. Investors are avoiding mortgage-backed investments and while are low, they certainly aren't as low as they should be considering the factors in the market and history.

There are many factors at play, but two are most obvious. The first is that there is a major black mark on mortgage investments right now. Even with equities sliding and fear of more Fed cuts, investors are putting a high risk premium on mortgage backed investments and won't invest unless the rates are higher. The banks won't lower the rates because their investors are basically saying they won't buy them. So rates stay higher to try to attract investors.

And the second factor only compounds the first, and that's that the lenders aren't opening the coffers. They got burned big-time on risky loans, and now they are being more selective, and are likely hoarding liquid assets, namely cash.

This is no simple issue to fully understand, but getting past the misconceptions and understanding the basic factors driving mortgage rates will not only help you in your investing, but in your own home-buying activities.