Private Equity Investment Public Equity Investment

Private Equity Investments - Final Exam

(July/ 4/ 2011)

Question 1-a

a. What are financial theory and concepts that support and rationalize activities of parties

involved in the events leading to the financial crisis?

Why and how did the meltdown happen?

Is the model used in the process wrong?

Answer 1-a

Moral hazard nurtured by Real estate and MBS bubble;

House prices of the United States had risen steadily since 1975. This trend accelerated in 1996, and reached about 12 percent per annum in late 2005 and early 2006. One reason for the rise in house prices is the Federal Reserve's policy of maintaining low interest rates after the 2001 recession.

Under these market situation, mortgage loan and mortgage backed securities market became more popular and bigger. The financial markets' appetite for mortgage product also resulted in more creative and complex financial products and strategies such as MBS (Mortgage-backed securities), CDO (Collateralized debt obligation), ABCP (Asset-backed commercial paper), Conduits, SIV (Structured investment vehicles). For example, according to the case, the S&L crisis also boosted the securitization of mortgages by two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Starting with bundles of mortgages purchased from mortgage originators, the GSEs created and sold mortgage-backed securities (MBSs), which delivered to holders the payments made on these mortgages. In exchange for a fee, the GSEs guaranteed the interest and principal on these loans. This meant that, assuming the GSEs remained solvent (or that the government came to their rescue if they found themselves in financial trouble), the only payment risk faced by the holders of these MBSs was the risk that the underlying mortgages would be repaid before they were due (known as prepayment risk). At that time, Popularity of "Subprime mortgages" was increasing. In the 1990s new firms started to lend money to borrowers that did not qualify for "prime" mortgages. In 1995, only 28% mortgage loan was a subprime level. In 2005, these subprime loan portion reached to 73%.

The end of real estate bubble and meltdown domino;

 House price usually fluctuated, but the recent bubble was unprecedented.

(doubled from 1997 to 2006)

 Increasing prime and subprime mortgages boosted the real estate market.

 The