bbThe eurozone crisis was the world's greatest economic threat in 2011, according to the OECD.

The crisis has festered since 2009, when the world first realized Greece could default on its debt. In two years, it escalated into the potential for sovereign debtdefaults from Portugal, Italy, Ireland and Spain. The European Union, led by Germany and France, struggled to support these members with bailouts from the ECB (European Central Bank) and IMF (International Monetary Fund). However, before it was all over the crisis threatened the concept and existence of the euro itself. How the Eurozone Crisis Would Affect You: If Greece, Italy or other eurozone countries defaulted on their debt, it would be much worse than the 2008 financial crisis for several reasons. Banks, the primary holders of sovereign debt, would face huge losses with smaller banks collapsing. In a panic, they'd cut back on lending to each other, and the LIBOR rate would skyrocket like it did in 2008. Even worse, the European Central Bank (ECB) holds a lot of sovereign debt, so its future would be at risk. Without a central bank to bail its members out, the EU itself might not survive. Left unchecked, the rippling effect of uncontrolled sovereign debt defaults could create a recession, if not a global depression. It would also be worse than the 1998 sovereign debt crisis. When Russia defaulted, other emerging market countries did too. However, the IMF stepped in, backed by the power of European countries and the U.S. This time, it's not the emerging markets, but the developed markets that are in danger of default. The major backers of the IMF -- Germany, France and the U.S. -- are themselves highly indebted. There would be little political appetite to add to that debt to fund the massive bailouts needed. If sovereign debt defaults were left unchecked, the resulting panic could cause a shutdown of credit, in which even the United States might have trouble funding its debt. What Was the Proposed Solution?: On December 8, 2011, the EU leaders agreed to a new inter-governmental treaty that would create a fiscal unity parallel to the monetary union that already exists. It would be finalized in March 2012 and then approved by all EU members. The treaty was designed to enforce the

budget restrictions of the Maastricht Treaty, reassure lenders that the EU would stand behind its members' sovereign debt, and allow the EU to act as a more integrated unit. Specifically, the treaty would create five changes: 1. Eurozone member countries would legally give some power over their budgets to centralized EU control. 2. Members that exceeded the 3% deficit-to-GDP ratio would face financial sanctions. Any plans to issue sovereign debt must be reported in advance. 3. The European Financial Stability Facility (EFSF) would be replaced by a permanent bailout fund, the European Stability Mechanism (ESM). The phaseout would begin in 2012 and take about a year. The permanent fund assures lenders that the EU would fully stand behind its members, substantially lowering the risk of default. 4. Voting rules in the ESM would allow emergency decisions to be passed with an 85% qualified majority. This would allow the EU to act more quickly. 5. Eurozone countries would lend another 200 billion to the IMF from their central banks. What Are the Consequences?: Initially, the UK and several other EU countries that aren't part of the eurozone balked at the treaty. If the treaty is ratified by only eurozone countries, it could lead to a "two-tier" EU. Eurozone countries may then create preferential treaties for their members only, excluding EU countries that don't have the euro. Second, eurozone countries must agree to cutbacks in spending. This could slow their economic growth, as it has in Greece. These austerity measures would be politically unpopular. Voter could bring in new leaders, who might leave the eurozone or the EU itself. Third, a new form of financing -- the eurobond -- becomes available. The ESM would be funded by 700 billion in euro bonds, fully guaranteed by the eurozone countries. Like U.S.Treasuries, these bonds could be bought and sold on a secondary market. By competing with Treasuries, the eurobonds could lead to higher interest rates in the U.S. (Source: CNN, Will new deal solve Europe's problems?, December 9, 2011)

Why the Deal Wasn't Enough: Debt ratings agencies like Standard & Poor's and Moody's want the ECB to step up and guarantee all eurozone members' debts. But EU leader Germany opposes such a move without assurances that debtor countries will install the austerity measures needed to put their fiscal houses in order. Germany does not want to write a blank euro check just to reassure investors. It is also paranoid about potential inflation, remembering only too well thehyperinflation of the 1920s. In addition, investors worry that austerity measures, needed in the long run, will only slow the economic rebound debtor countries need to repay their debts. (Source: CNBC, "S&P Says Eurozone May Need Another Shock",Euro Crisis Pits Germany and U.S. in Tactical Fight, December 12, 2011) How Did the Eurozone Get Into This Crisis?: First, there were no penalties for countries that violated the debt-to-GDP ratios set by the EU's founding Maastricht Criteria. Why not? France and Germany also were spending above the limit. They'd be hypocritical to sanction others until they got their own houses in order. There were no teeth in any sanctions except expulsion from the eurozone, which would weaken the power of the euro itself. The EU wanted to strengthen the euro's power, putting pressure on non-eurozone EU members, like the UK, Denmark and Sweden, to adopt it. (Source: BBC News, Greece Joins Eurozone, January 1, 2001; Greece to Join Euro, June 1, 2000). Second, eurozone countries initially benefited from the low interest rates and increased investment capital made possible by the euro's power. Most of this flow of capital was from Germany and France to the southern nations. This increased liquidity raised wages and prices, making their exports less competitive. Because they were on the euro, they couldn't do what most countries do to cool inflation -- raise interest rates or print less currency. Public spending rose, while tax revenues fell, during the recession to pay for unemployment and other benefits. (Source: Financial Times, Paul Krugman, Is Austerity Killing the Euro?) Third, although there are good arguments for austerity measures, they might only slow economic growth by being too restrictive. For example, the OECD said austerity measures would make

Greece more competitive by improving its public finance management and reporting, cutbacks on public employee pensions and wages, and lowering its trade barriers. In fact, exports have risen. More important, the OECD said Greece needed to crack down on tax dodgers, and sell off state-owned businesses, to raise funds. (Source: OECD, Economic Survey of Greece 2011) In return for austerity measures, Greece's debt has been cut in half. However, these measures have also slowed the Greek economy by raising unemployment, cutting back consumer spending, and reducing capital needed for lending. Greece may never grow its way out of its debt.

Definition: Subprime refers to a borrower that is not 'prime'. These are borrowers who might be less likely to repay a loan. Subprime borrowers may be classified as subprime because of:

Bad credit or lack of history Low income or poor debt to income ratios Large loans relative to the securing property (high LTV ratio) Maxed out credit cards

Referring to somebody as subprime is similar to saying they have less than perfect credit.

How Credit Works

When Youre a Subprime Borrower Borrowers in the subprime category often pay more in interest. Because theyre a greater risk for a lender, the lender charges a higher interest rate. Subprime borrowers often find themselves with alimited selection of products and lenders. Finally, subprime borrowers are often the targets of scam artists because a subprime borrower is typically more desperate to get a loan (they might also be viewed as less sophisticated).

Subprime Lenders The term subprime really refers to the borrower. However, some lenders are known as subprime lenders (or they make subprime loans). This means that they make a habit of working with subprime borrowers. In other words, their target market is the subprime borrower.

In 2007, the US economy entered a mortgage crisis that caused panic and financial turmoil around the world. The mortgage crisis was a result of too much borrowing and flawed financial modeling, largely based on the assumption that home prices only go up. Greed and fraud also played important parts. Lets review how the mortgage crisis unfolded. The American Dream Owning a home is part of the 'American Dream'. It allows people to take pride in a property and engage in a community for the long term. However, homes are expensive and most people need to borrow money to get one. The conditions were right for people to achieve that dream. In the early 2000s, mortgage interest rates were low, which allow you to borrow more money with a lower monthly payment. In addition, home prices increased dramatically, so buying a home seemed like a sure bet. Lenders understood that homes make good collateral, so they were willing to participate. The mortgage crisis was triggered as this situation built momentum. Cash Out With home prices skyrocketing, homeowners found enormous wealth in their homes. They had plenty of equity, so why let it sit in the house? Homeowners refinanced and took second mortgages to get cash out of their homes' equity. Some of this money was spent wisely, and some simply maintained a standard of living while wages stayed stagnant.

How Second Mortgages Work What Does it Mean to Refinance?

Easy Money Before the Mortgage Crisis Banks offered easy access to money before the mortgage crisis emerged. Borrowers got into high risk mortgages such as option-ARMs, and they qualified for mortgages with little or no documentation. Even people with bad credit could qualify as subprime borrowers.

What is Credit? High Risk Mortgages Low Documentation Loans

Fraud on the part of homebuyers and mortgage brokers helped make the mortgage crisis more serious. Mortgage applications were not checked for accuracy as well as they should have been. As long as the party never ended, everything was fine. Sloshing Liquidity Where did all that lending money come from? There was a glut of liquidity sloshing around the world - which quickly dried up at the height of the mortgage crisis. People, businesses, and governments had money to invest, and they developed an appetite for mortgage linked investments as a way to earn more in a low interest rate environment. Banks used to keep mortgages on their books. If you borrowed money from Bank A, youd make repayments to Bank A, and theyd lose money if you defaulted. However, banks now sell your loan, and it may be further divided and sold to numerous investors. These investments are extremely complex, so many investors just rely on rating agencies to tell them how safe the investments are (without really understanding them).

Mortgage Backed Securities CDO's (Collateralized Debt Obligations) Rating Agencies Faulted for Mortgage Crisis

Because the banks and mortgage brokers did not have any skin in the game (they could just sell the loans before they went bad), loan quality deteriorated.

Early Stages of Mortgage Crisis Unfortunately, the chickens came home to roost and the mortgage crisis began. Home prices stopped going up at a breakneck speed. Borrowers who bought more home than they could afford stopped paying the mortgage. Monthly payments increased on adjustable rate mortgages as interest rates rose. As homeowners discovered that they could not afford their homes, they were left with few choices. They could wait for the bank to foreclose, they could renegotiate their loan in a workout program, or they could just walk away from the home. Of course, many also tried to increase income and decrease spending but they were already on thin ice.

Mortgage Workout Programs Some Walk Away From Homes in Mortgage Crisis

Traditionally, banks could recover the amount they loaned at foreclosure. However, home values fell to such an extent that banks increasingly took hefty losses on defaulted loans. Mortgage Crisis Develops Once people started defaulting on loans in record numbers (and once the word got around that things were bad), the mortgage crisis really heated up. Banks and investors began losing money. Financial institutions decided to reduce their exposure to risk very quickly, and banks hesitated to lend to each other because they didnt know if theyd ever get paid back. Of course, banks and businesses need money to flow in order to operate. With bank weakness came bank failures. The FDIC ramped up staff in preparation for hundreds of bank failures caused by the mortgage crisis, and some mainstays of the banking world went under. The general public saw these high-profile institutions failing and panic increased. In a historic event, we were reminded that money market funds can break the buck.

How FDIC Insurance Works What Happens in a Bank Failure? Money Market Funds vs Money Market Accounts

Other factors contributed to the severity of the mortgage crisis. The US economy softened, and higher commodity prices hurt consumers and businesses. Other complex financial products started to unravel. Effects of the Mortgage Crisis Lawmakers, consumers, bankers, and businesspeople scurried to reduce the effects of the mortgage crisis. It set off a dramatic chain of events, and will continue to unfold for years to come. The public got to see 'how the sausage is made' and was shocked to learn how leveraged the world is. About.com has more on recent developments and economic recovery. For further information, see: