'Out of' means 'from', in the sense of transforming. If you transform A into B, you make B out of A. For example, I made a cool vest out of an old T-shirt of my dad's. I made a delicious dessert out of some left-over cookies and cream.

:) Ok, the actual meaning of this is that something is being blown out of proportion. Imagine how small a mole hill is and how large a mountain is. For example, "When she got a paper cut, she acted as if she had broken an arm. She really made a mountain of a molehill in this situation."

Yes, you start with a molehill and you create a mountain. "Out of" works perfectly here.