Rational Investing: Easy-money pileup suddenly backfires

Editor's Note: This is the second of a three part series that addresses the current financial situation. Click the link below to read Part I.

Wall Street's role in this complex issue is one that evolved over many years, with an innocuous beginning on May 1, 1975. It was then, after months of the pin-stripers lobbying against the change, that fixed-rate commissions on trades were eliminated.

In the 1971-75 period prior to the change, approximately half of the gross income of New York Stock Exchange member firms came from commissions. As of May Day (as it came to be called), that source of income shrank dramatically, with firms searching for products and services that would generate new sources of income.

Thus began an era of new products. It is beyond the scope of this column to detail all the investment vehicles that were created, including some that recall painful memories for many investors. For example: limited partnerships that were highly leveraged and without favorable tax treatment had scant investment merit; the euphemistically named high-yield bonds, aka junk bonds, the creation of which is credited to Mike Milken of the former firm of Drexel Burnham (more about that and his questionable legal treatment by Rudy Giuliani in a future column); and such "hot" products as country-specific closed-end funds, spurred by the Germany fund's incredible premium to its net asset value almost immediately after its initial public offering.

Enter then, during that halcyon time, the opportunities relative to the housing market. The Community Reinvestment Act of 1977 strongly encouraged (practically demanded) financial institutions to make housing more easily affordable to those of lesser means. (See the Nov. 17 Rational Investing column for more detail.) So credit standards became less stringent and mortgages began being issued to those of questionable ability to meet that financial obligation.

With the mortgage spigot turned on, somehow the full buckets at the banks, thrift institutions, and Fannie Mae and Freddie Mac had to be replaced with bigger or more buckets. Aha! The age of massive securitization provided the answer. By bundling mortgages and selling them as a package to institutions and the public, the burden could be spread among a lot of investors - not just the banks and thrifts.

At the same time, Fannie and Freddie, requiring funding to continue growing their mortgage portfolios, accelerated their issuance of bonds and preferred stocks, both types of investments that, because of their implied backing by the federal government, carried interest rates lower than those available to nongovernmental entities. And thereby Fannie and Freddie began leveraging their balance sheets to levels inconsistent with sound fiscal management.

The wheels were thus placed in motion for even more dubious mortgage lending, encouraging mortgage brokerage firms to spring up faster than dandelions. After all, with low credit standards, available funding through multiple banking sources, and Fannie and Freddie backing the mortgages, it was a piece of cake - a very profitable piece of cake.

And the borrowing continued by the banks, thrifts and our old friends Fannie and Freddie.

Happy were mortgagees, mortgagors, banks and thrifts, Wall Street, home builders and Realtors. West Coast and Sunbelt speculators were over the moon, and Fannie and Freddie were absolutely ecstatic.

Several actions kept the happy cycle going. After the necessary expansion of money in the system to allay the fear of financial Armageddon after Sept. 11, the Federal Reserve kept the money flowing, making leveraging even easier. Everyone in the loop was flush with capital.

Next month: the bottom falls out - so what does one do now?

Clark Davis is a 37-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company. He can be reached at cdavis@slia.com.