Over the next few years quite a few doctoral dissertations are going to be written about the sub-prime loan market, and its effects on the overall U.S. economy.  And whatever the effects turn out to be, it is certain that this financial crisis has all the twists and turns of a spy novel.  Here is part of the plot. 

Over the past decade and half home prices skyrocketed.  The causes included rapid growth in the U.S. economy, aging baby-boomer purchases of vacation home and most importantly, low mortgage rates.    

In many places, these rapid home price increases made buying a family home difficult for the average family.  But, financial institutions, struggling with low interest rates, offered a new set of financial instruments and pushed some older ones.  We now call these sub- prime loans.    

In the 1980s, Congress created Freddie Mac and Fannie Mae, the financial market giants, primarily to construct a market for mortgage  backed securities. Congress did this to extend the opportunities for mortgage loans. The effort worked well, and mortgage loan availability extended nationally.    

After 9/11 the U.S. government deficit rose, while consumers continued to spend, while interest rates remained low. This places downward pressure on the dollar, and exchange rates drop.  Since oil is denominated in dollars, our energy prices rise.    

That’s the background, here’s the spiral of events.  

In 2005, modest evidence of inflation and a robust economy leads the Federal Reserve to raise rates.  This led to increases in adjustable rate mortgages, with some inevitable foreclosures. Here’s the kicker though, no one really knows how extensive this may be.  We do know that 20 years ago only about $200 million worth of mortgages were floating around secondary markets.  Today, it is $2.2 trillion. Most of these loans are not sub-prime, and even most of the sub- rime borrowers are happily living in their homes – in no danger of foreclosure.    

To place the magnitude of the mortgage securities, and at-risk loans in context, we would do well to remember our economy is $13 trillion annually, with nearly $50 trillion in loans of one sort or the other.  $200 million is rounding error on this figure, and so even if a quarter of the traded mortgages are bad – some $500 million or so, there is no crisis.    

Again, the real worry is that we don’t know how many mortgages will default, and this uncertainty causes the share price of financial institutions to drop.  The problem arises from this devaluation of assets (and inability to borrow further).  For banks must have financial resources in order to make loans.  Without loans, the economy does not work.   

Still, this may well turn out to be the ebb and flow of business.  Perhaps most telling, mortgage rates have declined, sure evidence that no credit crunch has yet emerged.  Most importantly, policy makers haven’t even begun to employ the tools of monetary and fiscal policy that are available.  Whatever does happen, the next few months will be a real thriller.