In a column for the Wall Street Journal, the always-insightful Jeremy Seigel, a professor of finance at the University of Pennsylvania's Wharton School (and author of Stocks for the Long Run), gets to the heart of what led to the financial meltdown.

The key, he writes, can be found in data collected by Prof. Robert Shiller of Yale University.

According to [these] data..., in the 61 years from 1945 through 2006 the maximum cumulative decline in the average price of homes was 2.84% in 1991. If this low volatility of home prices persisted into the future, a mortgage security composed of a nationally diversified portfolio of loans comprising the first 80% of a home's value would have never come close to defaulting.

The credit quality of home buyers was secondary because it was thought that underlying collateral - the home - could always cover the principal in the event the homeowner defaulted. These models led credit agencies to rate these subprime mortgages as "investment grade."

But this assessment was faulty. From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gain in the consumer price index or the paltry 1% rise in median household income. Never before have home prices jumped that far ahead of prices and incomes.

The stratospheric rise in housing prices should have set off warning bells. Well, actually it did - but few were listening.

[Warnings] were ignored as Wall Street was reaping large profits bundling and selling the securities while Congress was happy that more Americans could enjoy the "American Dream" of home ownership. Indeed, through government-sponsored enterprises such as Fannie Mae and Freddie Mac, Washington helped fuel the subprime boom....

The fact that the yields on these mortgages were high despite their investment-grade rating indicated that the market was rightly suspicious of the quality of the securities, and this should have served as a warning to prospective buyers.

With few exceptions (Goldman Sachs being one), financial firms ignored these warnings. CEOs failed to exercise their authority to monitor overall risk of the firm and instead put their faith in technicians whose narrow models could not capture the big picture.

Seigel also faults the Fed (both Greenspan and Bernanke) for not sounding an alarm. "For all the deserved kudos that the central bank received for their management of the crisis after the Lehman bankruptcy, the failure to see these problems building will stand as a permanent blot on the Fed's record," he writes.

Perhaps the wisest words ever uttered about bubbles came from the late economist Herb Stein. "If something cannot go on forever, it will stop," he said. So simple, it's profound. You'd think that the wizards of Wall Street, the overseers in Congress, and the banking professionals at the Fed would all have been asking, "What is going to happen when this unsustainable increase in housing prices finally stops? Who will be left holding what?" But they didn't.

Maybe we'll know better next time. Then again, maybe not.
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Joseph Slife is a contributing author and editor for SMI. Visit www.soundmindinvesting.com to learn more.