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Additional participants are also involved:
Servicers—who keep the loan documents and collect the payments from the borrower
Rating Agencies—that place a rating on the mortgage securities and on the CDO debt
Investment Banks—that act as underwriters and placement agents for the mortgage securities and the CDO debt
This description is obviously a simplification of a more complex process. For example, CDOs were not the only purchasers of risk in the sub prime market. They were however a dominant player, with some estimating that they bought about 70% of the lower rated classes of sub prime mortgage securitizations. What is clear even from this simplified process is that the investor in the CDO bond has attenuated contact to the borrower. While six degrees of separation creates a smaller global community, it is not sufficiently close to insure a sound mortgage origination process.
When is a Door Not a Door?
One of my favorite riddles from childhood is “When is a door not a door?” The answer is: “When it’s a jar (ajar).”
That is the problem with the current secondary market, especially for sub prime loans: no one is the gate keeper, shutting the door on uneconomic loans. Rather than conducting his/her own analysis, the ultimate CDO investor, to a large extent, placed trust in the first loss investor, the rating agencies and the CDO manager. In each case that trust was misplaced.
In the secondary market, mortgage transactions are generally structured so that someone at zero or one degree of separation would take the first slice of credit risk and thus insure that loans were originated properly. In the sub prime market, however it was possible to originate loans and sell them at such a high price, that even if the mortgage banker or aggregator retained a first loss piece (or residual) the transaction could be profitable even if the loans did not perform well. Furthermore, the terms of the residuals were set so that the owner of the residual might receive a substantial portion of their cash flows before the full extent of losses were known.
