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How did the economic crisis get started?

This question asked by Anonymous

Long before there was a full-fledged financial crisis, there was a bubble in real estate prices. The bubble was created by two misguided practices. First, lending standards in the mortgage industry eroded. This enabled many lower-income households to purchase homes at reduced interest rates or with lower down payments. Reduced lending standards were not brought about by market forces, but rather changes at Fannie Mae and Freddie Mac, two government-sponsored enterprises designed to provide liquidity in the mortgage market.

Fannie Mae and Freddie Mac do not originate mortgages.  They purchase mortgages originated by banks and other mortgage brokers in what is known as the secondary market. The secondary market creates an odd set of incentives. Before the secondary market existed, lenders (who originated mortgages), were responsible if the loan went bad. However once the secondary market was created, many banks who originated loans offered them to Fannie Mae and Freddie Mac. This creates a huge principal-agent problem. The agent (or bank) who sold the good (in this case a mortgage to a new homeowner) did not have any responsibility to make sure that the contracting party (the buyer) lived up to the contract. Because the risk of default was transferred to the secondary market, individual banks no longer scrutinized loans as thoroughly as they should have. Mortgage originators had an incentive to look the other way.

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