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These agencies, as well as the mortgage insurance companies, bore the risk of default. To protect themselves they established underwriting criteria for the types of loans they would own or guarantee. While they did not originate loans (and are prohibited from doing so), they are actively involved in monitoring the process of loan origination.
To further insure the performance of purchased loans, the mortgage market has developed the practice of requiring “Representations and Warranties” on purchased loans. These Reps and Warrants as they are called, are designed to insure that the loans sold meet the guidelines of the purchasers. This is because mortgage market participants have long recognized that there is substantial risk in acquiring loans originated by someone else. An essential component in having valuable Reps and Warrants is that the provider of those promises has sufficient capital to back up their obligations to repurchase loans subsequently determined to be inconsistent with the Reps and Warrants. A financial guarantee from an insolvent provider has no value.
Six Degrees of Separation
The current secondary market for non-agency mortgages, including sub prime mortgages has many participants and a great separation of the origination process from the investment process (See Diagram). Each participant has a specialized role. Specialization serves the market well, as it allows each function to be performed efficiently. Specialization, however also means that risk creation and risk taking are separated.
In simplified form the process can be described as involving:
Borrowers—who want a loan for home purchase or refinance
Brokers—who work with the borrowers and lenders to arrange the loan
Mortgage Bankers—who fund the loans and then sells the loans
Aggregators—(often a broker-dealer) who buy loans and then packages the loans into a securitization that are sold to investors
CDO Managers—who buy portfolios of mortgage-backed securities for a trust that issues debt backed by those securities
Investors—who buy the CDO debt
