The cause was the housing bubble, but just how did we get there? In 2001 after the dot.com collapse, housing prices actually rose. This gave a false sense of security to real estate. The FED kept interest rates way down and this spurred demand for housing. With government programs like the Community Reinvestment Act, banks were encouraged to loan to potential buyers who normally could not qualify. Historically it was very difficult for buyers to get a loan with a FICO score of less than 660. But the standards were lowered. In 2003 Only 8% of loans were sub-prime. But by 2007 it had jumped to almost 25%. Nonetheless, the sub-prime mortgages were not scams. The intent was to eventually convert them into conventional mortgages once equity was built.
Lowering the standards for loans enabled home ownership to climb from 64% in 1994 to 69%. Freddy and Fanny were major players in creating the housing bubble. They would buy mortgages from banks and repackage them into mortgage backed securities. The banks would then have more money to lend.
In the Fall of 2003 the Bush Administration raised concerns about GSEs like Freddy and Fanny. They sent Treasury Secretary John Snow to Congress in an attempt to create a new regulatory agency to reign in the GSEs. But they got serious pushback from Congress, and the legislation was blocked. In 2005 the FED Chairman Alan Greenspan added his voice before Congress about a systemic problem with GSEs and the need to reign them in and strengthen the regulations over them. But the two mortgage giants had staunch defenders in Congress, and Greenspan's pleas were ignored. Our fate was now sealed.
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