Rational Investing: The Financial Mess: How did we get here?

Editor's Note: This is the first of a three-part series addressing the current financial crisis.

Set aside your political party preference, and as logical, inquisitive, nonpartisan (boy, did they over use that word during the Congressional bailout negotiations) individuals, let's look at some of the actions through the decades that brought the financial system to where it is.

It all began in 1938 when, still in the economic morass of the Great Depression, Congress established the Federal National Mortgage Administration to make available financing for potential homebuyers. It remained under government control until 1968, when it became a private, shareholder-owned entity chartered by Congress.

This quasi-private, quasi-public operation, favored by politicians as a means to meet their perceived national housing needs, then began its biggest growth period.

Fast-forward to 1977, when the Community Reinvestment Act required banks to expand their loan activity, including mortgages, to those in poor communities.

Banks, which were subject to regulatory discipline if they failed to do so, were required to create a plan to comply with the act. That laid the framework for lowering lending standards, again, for perceived social good - making homes available for the poor.

In the 1990s, an attempt was made by a senator to insure that the CRA requirements were based on sound financial footings, but he was unsuccessful.

Four years ago, another senator made a similar effort, to no avail. Note that I intentionally have not named names. Place these where you feel they belong throughout: Alan Greenspan, Phil Gramm, Barney Frank, George Bush, Franklin Raines, Charles Schumer, John McCain, Jimmy Carter, Maxine Waters and Bill Clinton.

Following the 1977 act, and all the way to the present, Fannie Mae and Freddie Mac have grown the amount of the mortgages held, while shrinking their capital to levels not allowed for corporate America. Operating with the implied guarantee of the federal government (oh, was this a strong selling point for investors) and continuing to contribute to politicians who supported their arcane lending and accounting methods, both government-sponsored enterprises expanded their portfolios while further lowering their lending standards, hence the categories of sub-prime and Alt-A came into being, the latter often referred to in the lending industries as "liar loans."

Attempts by several senators, representatives and the White House have been made several times to tighten the accounting, lending requirements and transparency of both GSEs, but congressional opposition by several in Congress who have been the beneficiaries of Fannie's and Freddie's lobbying and contributions have prevented such requirements.

Several of the legislators who are currently railing about the lack of regulation under the current administration are the very ones who most adamantly opposed such measures, even to the point of defending Fannie and Freddie and their good work, while both entities were beginning to crumble financially.

So the social good of providing affordable housing took priority over financial viability.

Exacerbating the problem in the early years of this century was the easy money policy of the federal reserve chairman, which held interest rates low and expanded the money supply well after the emergency created by the 9/11 crises. Easy money means easy credit, which means more dollars chasing limited goods, which means asset values are driven up. In this case, the upward spiral took place in almost all commodities, but more noticeably to most individuals was the unprecedented increase in housing prices. Mortgage companies sprang up almost overnight. Creative financing made funds available for many who could not afford them but believed that rates would stay low and their house values would increase. If rates did go up they could just sell the house, realize the profit, and move on.

Next month, we'll look at how Wall Street exacerbated the problem and where that takes us.

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.