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Six Degrees of Separation

December 18, 2015

By Andrew Davidson

In the simplest terms, what went wrong in the sub prime mortgage market is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made.

The capital markets are a wonderful vehicle for transferring risk and providing capital to lending activities. But when the transfer of risk leads to a lack of diligence, markets become dysfunctional. To see how this can happen, let’s start with the most basic lending transactions.

One Degree of Separation

For much of the last century, it was the savings and loans, or “Thrifts” that provided the bulk of the mortgage loans. In the traditional lending model, the Thrift raised money via deposits from its customers and then lent that money to other customers for home purchases. If the borrower was unable to make its mortgage payments, the Thrift would suffer the consequences directly. With the advent of deposit insurance, the depositors were protected and the only risk was to the capital of the institution. With limited risk management capability and limited ability to raise deposits outside of their home markets, Thrifts were subject to a boom and bust cycle that meant that capital flows for mortgage lending were uneven.

Two Degrees of Separation

The secondary market for mortgages was developed to separate the process of creating loans from the capital required to fund the loans. In the secondary market, the risk of borrower default would be transferred to an investor. Investors for the most part however, were unwilling to take on the risk of borrowers they did not know. To facilitate the availability of capital, Ginnie Mae, Fannie Mae and Freddie Mac were established. Without getting into the full history or details, the main impact of these agencies was to take on the credit risk of borrowers and allow other financial market participants to provide the funding for the mortgages.

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 The Pipeline - Special Edition, August 2007 - 2 - © 2007 Andrew Davidson & Co., Inc. 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. 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.

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CFLA was founded by the Nation's Leading Foreclosure Defense Attorneys back in 2007 to serve the Foreclosure Defense Industry and fight pervasive Bank Fraud. Since opening our virtual doors, CFLA has rapidly expanded to become the premier online legal destination for small businesses and consumers. But as the company continues to grow, we're careful to hold true to our original vision. For us, putting the law within reach of millions of people is more than just a novel idea—it's the founding principle, just ask Andrew P. Lehman, J.D.. With convenient locations in Houston and Los Angeles, you can contact Our National Account Specialist and General Manager / Member Damion W. Emholtz at 888-758-2352 for a free Mortgage Fraud Analysis or to obtain samples of work product, including cutting edge Bloomberg Securitization Audits, Litigation Support, Quiet Title Packages, and for more information about our Nationally Accredited and U.S. Department of Education Approved "Mortgage Securitization Analyst Training Certification" Classes (3 days) 24 hours for approved CLE & MCLE Credit (Now Available Online).

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