The financial crisis happened because the financial institutions were allowed to operate with very lax oversight. This resulted in them pursuing policies that were very profitable but at the same time very risky. Everything was fine while the economy remained strong but as soon as things started to change it turned what should have been a minor economic downturn into a crisis. The main issue was that banks that were issuing mortgages were packaging those mortgages together and selling them to investors. This is what caused the crisis to really get out of hand.

The problem with allowing the banks to package the mortgages and then sell them to investors is that the banks no longer had any incentive to make sure that the mortgages that they were issuing were good risks. Since they weren't the ones who would have to collect the payment they had an incentive to issue as many mortgages as they possibly could. This inevitably led to the giving mortgages to people who couldn't afford them. When the Federal Reserve decided that they needed to raise interest rates all of those people found themselves unable to pay their bills and they began to default on their mortgages.

Even all of the bad mortgages was not in itself a disaster since the number of them was fairly small compared to the total number of mortgages. The problem was that to sell the bad mortgages to investors the banks bundled them together with good mortgages. This meant that nobody really knew who owned the bad mortgages. This is what really caused the crisis. Since nobody really knew who was going to get stuck with the bad mortgages everybody stopped lending money out of fear that they would lend to somebody who would go bankrupt because they were holding some of these bad mortgages.

It was this complete shutdown of the credit market that really caused the crisis. Without credit businesses can't operate and they had to start laying off employees. This of course just made the problem worse since there were now all of these laid off employees who could no longer pay their mortgages. This lead to more investors being stuck with bad mortgages and the whole economy found itself in a downward spiral. The problem was made worse by the fact that for years the Federal Reserve had kept interest rates very low. The normal solution to the problem would have been to encourage the credit markets by lowering rates. The problem was the rates were already so low they couldn't do this.