What Caused the Economic Crisis?

Here's a very succinct and very accurate assessment by Bill McBride on his Calculated Risk blogging site:

About two years ago, I was asked to sum up the causes of the crisis in a few words, and I responded "Securitization and the lack of regulatory oversight". I then explained how rapid innovation in lending resulted in a disconnect between the borrower and the eventual debt holder.

The mortgage lenders and Wall Street firms were disconnected from the performance of the actual loan (the "Originate-to-sell" model). At the same time, the rating agencies were evaluating the debt based on the historical performance of the old style lender-borrower relationship. The eventual debt holders relied on the rating agencies, without realizing the entire model had changed.

Meanwhile the regulators were not following this advice:

“Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”
William Seidman, "Full Faith and Credit", 1993.

There is nothing inherently wrong with securitization or financial innovation. But the regulators should always be on the lookout for "a new way to make a loan that will not be repaid".

The original post has some bits from an interview by the Washington Post with Congressional representative Barney Frank that is worth reading as well.