With storm clouds hanging over the U.S. economy, Federal Reserve Chairman Ben Bernanke has gone on the offensive, slashing the federal funds target rate by 3 full percentage points—to 2.25 percent—since September. But despite the central bank's aggressive action, prospective homebuyers are left scratching their heads. After all, the average interest rate on a 30-year, fixed-rate mortgage has fallen by only about half a percentage point, to 5.85 percent, since mid-September. So what gives?

Here's a look at the factors influencing today's mortgage rates and a peek at where rates might be headed.

Does the Fed set mortgage rates?



No. The Fed is responsible for setting the federal funds target rate, which is the interest rate that banks charge each other for overnight loans. "A bank's balance sheet needs to balance every day," says Ken Mayland, president of ClearView Economics. "If a bank needs funds, it will borrow. If it has a surplus, it will lend—at the federal funds rate." Interest rates on short-term certificates of deposit and commercial paper are closely linked to the federal funds rate, Mayland says, but its influence on fixed-rate mortgages is less direct. Does the federal funds rate affect mortgage rates?



Only indirectly. The fed funds rate affects a lender's borrowing costs. When the federal funds rate is cut, lenders pay less for the funding they need to finance loans. As such, they can reduce the interest rates they charge on mortgages without hurting their profit margins. "You're not looking at any kind of direct relationship," says Christopher Thornberg of Beacon Economics. "When you think about a fixed-rate mortgage, you're talking functionally about a 30-year bet of which the short- run costs of capital are but a minute part." So what are the key factors that determine mortgage interest rates?



Fixed mortgage rates typically track the yield on the 10-year treasury note. "The 30-year mortgage tends to have roughly the same [sensitivity to interest-rate changes] as a 10-year treasury," says T.J. Marta, a fixed-income strategist at RBC Capital Markets. "On average, people pay off their mortgage roughly every 10 years." The outlook for inflation plays a key role in determining the yield on the 10-year treasury, Marta says. In order to compensate lenders and investors for the risk that home loans will not be repaid, mortgage interest rates are set higher than the yields on 10-year treasuries, which are essentially risk free. Historically, the typical difference between mortgage rates and the 10-year treasury yield—known as the spread—has been roughly 1½ percentage points. In the mortgage industry, the difference between these two rates is often referred to as a "risk premium."

How have those factors influenced mortgage rates lately?



Although 10-year Treasury yields have declined in recent months, risk premiums have widened dramatically. The spread between the average 30-year fixed mortgage rate and the 10-year Treasury yield has ballooned nearly 60 percent over the past year, to about 2½ percentage points, according to HSHAssociates.com, which tracks mortgage rates. "That spread—the normal 1.5 percentage points—has gone haywire," says Orawin Velz of the Mortgage Bankers Association. What is driving up those risk premiums?



Before the housing crisis, mortgages were considered safe investments, so risk premiums were slim. During the housing boom, huge swaths of home loans were pooled together and sold to investors in the form of mortgage-backed securities. But rising delinquencies on subprime home loans led to large-scale losses for investors holding such products. With demand for mortgage-backed securities evaporating, higher returns were required to attract new buyers, who were fleeing to safer investments like treasury securities. Meanwhile, banks—which have absorbed billions of dollars in losses since the onset of the crisis—have been requiring tougher underwriting standards and wider spreads on new mortgages.

"The spreads [between the 10-year treasury yield and mortgage rates] are wide because of a pickup in defaults and delinquencies and an expectation of more to come," says Michael Darda, chief economist at MKM Partners.

As a result, the recent declines in the yield of the 10-year treasury have been more than offset by the escalating risk premiums. That has prevented mortgage rates from falling as much as they otherwise might.

Will these risk premiums decrease anytime soon?



As portfolios begin to heal from the housing market's wrath, risk premiums should begin to decrease, says Keith Gumbinger, vice president of HSHAssociates.com. "We'll start to get to a point where lenders will feel more comfortable passing along more of those declines in interest rates [to customers] and certainly expanding—nibbling at the fringes—of lending they used to embrace wholeheartedly," Gumbinger says. "So you should see some of those risk premiums start to decline, especially for the best credit quality borrowers." Indeed, the risk premiums have decreased recently—although they remain well above historical norms. Gumbinger credits the narrowing in part to recent changes allowing government-sponsored mortgage finance giants Fannie Mae and Freddie Mac to increase their holdings of mortgage-backed securities. "Lots of liquidity is becoming available to good credit quality borrowers," he says.

What's the outlook for the 10-year treasury?



While risk premiums may decline, the 10-year treasury yield is expected to increase. Marta of RBC Capital Markets expects the yield to be about 3.9 percent by the end of the year, up from its current yield of about 3.5 percent. "Back in January, on the [Société Géneralé] meltdown, we made our second-lowest yield in [modern] history," Marta says. "I don't really see that yields are going to get a whole lot lower than this." So where will mortgage rates be at the end of the year?



Velz of the Mortgage Bankers Association expects the rate on the 30-year fixed mortgage to be just over 6 percent at the end of the year. Rates could go lower, she says, should the economy slip into a protracted recession—which she does not expect. How attractive are current mortgage rates?