Editor’s note: “The Economic Situation” is a regular overview of the U.S. economy written by Bruce Yandle, dean emeritus of the College of Business & Behavioral Science at Clemson University. This excerpt of the report is reprint with permission of Clemson University.

CLEMSON, S.C. – The sub-prime blues.

The sub-prime market collapse is a story that just keeps getting worse. When problems associated with defaults on low quality mortgages first surfaced a few months ago, the data suggested a serious problem was working its way through financial markets, but not a problem so severe that it would disrupt world financial markets. The problem is larger than first realized. But when saying this, we should know immediately that the magnitude of the problem relates to interest rates. If interest rates fall, so falls the magnitude of the problem. The problem has grown as interest rates have risen. Saying this opens one more can of worms. Once defaults set in, there is a kind of financial contagion that causes more defaults. Credit conditions tighten; cash becomes scarcer; asset prices fall; and borrowers that otherwise might just be marginal but okay become sub-marginal and not okay. And people suffer.

There are really two parts to the problem. The first relates to expanded lending in a low interest rate environment with a lot of creative finance and perhaps a little fraud. As a result, people who might otherwise still be renting, became homeowners. The other part relates to uncertainties generated by Federal Reserve monetary policy. By this I mean that most lenders could not have predicted that the Fed would increase interest rates 16 successive times during the interval when adjustable rate mortgages were to reset, and by doing so cause lots of mortgages to go belly up. I should add, that this part of the problem is not over. A large amount of mortgages will reset in the next 12 months.

The relative magnitude of the sub-prime mess was described cogently in an August 8 analysis by Economy.com’s Mark Zandi. First off, he reports there are some $2.5 trillion in sub-prime and related outstanding mortgages, an amount equal to 25% of all mortgage balances. Of these some $1.3 trillion are in serious risk of default. Now this doesn’t mean that the whole $1.3 trillion just goes up in smoke. A part of it does. Those assets and the housing associated with them will be repriced. The houses stay in the economy. Some of the financial assets go down the drain.

The at-risk group was originated between 2004 and early 2007. As Zandi points out, there was less than 10% equity in the mortgages at the time of origination. Since then interest rates have ratcheted up, housing prices have fallen, and the equity has disappeared. One other tidbit to consider, some $1 trillion or 34% of the banking system’s assets are in residential mortgages, up from $800 million or 24% in 2002.

Default on mortgages or other loans destroys a family balance sheet, and sometimes a family. Default also destroys money in the economy. When loans are made, the money supply increases; when paid off, money is destroyed, but new loans and money can be created as credit markets rewind. Destroyed money that is not replaced by lending disturbs the economy. The Fed acts to cushion the shock.

Accordingly, the Fed has pumped huge amounts of money, some $80 billion, into the market in the last half of August, and to make certain that cash entered, the Fed reduced the discount rate and encouraged banks to borrow. They obliged.

Did we know it was coming?

Consider this by Daniel Gross, Slate, May 12, 2006:

“The Federal Reserve raised rates again earlier this week, the latest in a string of 16 rate increases that have pushed the Fed’s overnight lending rate from 1 percent to 5 percent in two years. The Fed’s actions, combined with growing concerns about inflation, have helped push short-term and long-term rates up across the board.

“In real-estate, the adjustable-rate bomb could be even bigger. Home-buyers have increasingly turned to adjustable-rate mortgages (or ARMs) as prices have escalated. ARMs allow borrowers to lock in a lower rate in the short term in exchange for accepting the risk that they’ll pay more in the future if interest rates rise. With every passing month, however, as mortgage rates rise, more and more borrowers are stuck with higher monthly payments.

According to the Office of Federal Housing Enterprise Oversight, the volume of ARMs tripled between 2001 and 2004, from $304 billion to $985 billion in 2004. At the end of 2004, there were about $1.4 trillion in ARMs outstanding. That figure is likely significantly higher today, since the ARMs accounted for about 31 percent of the $2.9 trillion in mortgages issued in 2005, according to the Mortgage Bankers Association. For every 100 basis points (i.e., 1 percent) mortgage rates rise, holders of adjustable of ARMs will owe an extra $14 billion per year in interest.”

Gross and others called attention to the effects of the Fed’s battle against inflation on housing finance. And so we have a housing finance catastrophe.

So where does this take us? First, GDP growth over the next nine months will be reduced by a half percentage point or so. Second, the Fed will face a dreaded test. Reduce interest rates and encourage inflation or hold the line and encourage recession. All bets point toward an interest rate reduction in September 2007. And third, will the Fed learn from this and change its method for managing monetary aggregates? Let us hope that the days of interest rate roller coaster rides are behind us. Let us also hope that congress and state legislatures do not rush to pass “protective” legislation that will unduly regulate mortgage markets.

For the complete report, see the Web link with this story.