Private Equity Fund Final Take Home Exam Essay
(July/ 4/ 2011)
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?
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 …show more content…
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. * [U.S. Foreclosures]
The house prices were like a bubble ready to burst
* Borrowers were needlessly placed in expensive subprime loans, and many loans were given to people who could not repay them. * The Collapse of the base of the subprime loan securitization was inevitable.
Wrong assumptions and player’s greed;
The model is used in the process was not wrong. Yet, there are some incorrect assumptions in the process. The basic assumptions in the process that housing price will rise or at least not fall and that historical probability of default rate can apply to future default rate turned out to be wrong.
There are, also, some mistakes and negligence in the process.
Today, when a bank makes a home loan, it doesn't hold on to it. Instead, it quickly sells the mortgage off to financial engineers, who chop up, repackage and resell home loans.
Investment banks didn’t care about the stability of underlying asset(subprime mortgage), but just issued as much CDOs as they can, and sold these CDOs to clients as a “safe securities”.
Rating agency just “sold” their