The sub-prime mortgage industry crisis has claimed its first victim, American Home Mortgage, and now it’s setting its sights on another mortgage lender, Countrywide. I probably wouldn’t care, except that Countrywide is my mortgage company. I’ve got good credit, so I’m not worried about having a bankruptcy court call on the assets of my house if Countrywide were to fail, but even so, having my lender in distress is something I’d really rather not have to deal with.

What’s absolutely nuts about this, though, is that Countrywide isn’t a sub-prime lender. Countrywide is a full financial company, and the mortgage subsidiary has the backing of a bank with which to control risk and fund operations of the wider company. Over 90% of the mortgages that Countrywide handles are “prime” loans, not sub-prime. And yet Countrywide has been painted with the same brush as sub-prime lenders New Century and American Home Mortgage. Countrywide’s recent debt downgrading and stock price collapse are totally irrational.

Unfortunately, the financial markets have stopped being rational when it comes to the mortgage business, something that Washington Post commentator Sebastian Mallaby and WashPost/Newsweek commentator Robert J. Samuelson have both commented about recently.

Mr. Mallaby’s commentary today (A Market Run on Rationality) on the Countrywide debacle describes what we’re seeing in the mortgage section of the financial sector as a “panic”.

The most vivid image amid last week’s financial turmoil came from Calabasas, Calif., home to the nation’s biggest mortgage lender, Countrywide Financial Corp. At a retail branch down the street from Countrywide’s headquarters, depositors reportedly “besieged” a representative on Thursday, demanding to get their money out. The next day similar scenes played out at other Countrywide branches, conjuring those grainy black-and-white images of Depression-era bank runs. “I know a little about what happened in the 1930s,” one customer told Reuters. “It smells like it could be the same.”

These vignettes may have been swollen out of proportion by the journalistic magnifying glass, but they capture the essence of the moment. For the chaos in the markets has become as scary and as arbitrary as an old-fashioned bank run. Fear has taken over, and sound institutions are suffering along with poorly managed ones. It is a reminder that the markets are an exquisite instrument for pricing risk and allocating capital — except during those brief periods when they go stark raving nuts.

Mr. Mallaby posits that the panic is ongoing because the rational people in the stock and bond markets haven’t been able to borrow enough money to offset the crazies due to the credit crunch. If this is true, then the Fed’s actions last week indicating that they’ll accept higher inflation for a while if it stabilizes the financial markets and protects solid companies like Countrywide make a great deal of sense. After all, while the Fed’s job may to keep inflation down, as Mr. Mallaby says, it’s even more important to stop a panic by lending money to banks as a last resort.

Unfortunately, something that Mr. Samuelson said in his commentary (High Finance Roulette) makes me a little more nervous about the Fed’s ability to stall the panic than I would be otherwise. Mr. Samuelson points out that the economy of the U.S. is highly dependent on the health and rationality of the markets, yet there have been so many recent changes in how the market works that rationality may not even be possible.

Many subprime mortgages have gone into default. [Collateralized debt obligation security] investors are suffering losses. The credit cycle has reversed: Investors have retreated; credit standards have tightened; home buyers are scarcer; housing prices are dropping; it’s harder to borrow against home values; consumer spending is weakening. Whether this will cause a recession is unclear.

But it captures a larger dilemma. Capital markets are not just incidental to economic growth. They’re a force for both good and ill. The recent financial innovations have made it easier for countries, companies and individuals to borrow and tap investment capital. Many types of credit (auto loans, business loans) have been “securitized,” unlocking new sources of money. New financial institutions have flourished: “hedge funds,” pools of capital provided by pension funds and wealthy investors; “private equity” funds, with money from similar sources.

The peril is that so much has changed so quickly that no one knows how the system operates. It’s often roulette. Monday’s defensible investment may become Tuesday’s silly speculation. Global markets are interconnected, and financial conditions are tightening. Some hedge funds—including foreign funds—have suffered huge losses on U.S. subprime mortgages. These could harm banks that lent to hedge funds. Up to a point, losses are inevitable and desirable. They remind investors of risk. But too many losses—too much fear of the unknown—can trigger a chain reaction of selling and credit contraction. This must worry the Federal Reserve and other government central banks.

I find the statement “so much has changed so quickly that no one knows how the system operates” downright scary. We’ve trusted a significant portion of our economic health to a system that no-one really understands, and that’s never a good idea. And Mr. Samuelson is right – the Fed is worried, as Mr. Mallaby’s commentary pointed out.

Not only are we having our own financial market problems, but the U.S. has threatened to impose sanctions against China if they don’t allow their currency to trade in a wider range against the U.S. dollar (this is important because part of our trade deficit is a result of an artificially low trading value of the yuan to the dollar). In response, two Communist Party organizations suggested that China might respond by dumping some or all of the ~$1.3 trillion held by the Chinese government. This has added even more to market nervousness given that a dumping of currency onto the markets could cause a recession in the U.S. However, unlike the market panic regarding mortgage companies, it’s unlikely that China would actually dump their debt. After all, if they did so without freeing the yuan at the same time, the collapse of the dollar would suck the yuan down with it. And if dumping dollars caused a recession in the U.S., it could easily cause a recession in China’s economy as well. After all, trade with the U.S. accounts for 7.5% of China’s entire economy, while U.S. trade with China accounts for only 0.4% of the U.S. economy. Even former Fed Chairman Alan Greenspan says that China won’t dump dollars, although his reason isn’t one we should cheer about – China probably couldn’t find enough buyers.

So, we have a situation where the financial markets have changed so much recently that no-one really understands how they work any more, people are panicking and attacking financially-sound institutions like Countrywide instead of focusing exclusively on institutions that are actually unsound, and politicians both here in the U.S. and internationally are going out of their way to make things worse instead of better.

The only way out of this situation is to be patient, to make carefully considered and gradual changes, and let the markets and government(s) work together to restore rationality. This means putting a stop to ill-considered threats of trade sanctions out of Senate committees and the government shoring up financially-sound companies like Countrywide while allowing financially busted companies like American Home Mortgage to fail.

It also means that we all have to accept some personal economic pain, in the form of reduced 401k yields, stagnant or falling home prices, higher credit interest rates, etc. And when rationality does finally reassert itself, the economy will be better off for it.