This happens at the time the content is output the browser. At that point, the content is passed through several filters, one of which is called wpautop. This filter function is defined in wp-includes/formatting.php. In combination with the other default WordPress filters, this generally means that you can compose content in the HTML (non-wysiwyg) editor as if you were writing plain text, and it will format the final HTML output in a logical, intuitive manner.
On the other hand, you can also feel free to manually compose HTML tags in your output, and WP will preserve your tags. There are some edge-cases that can get you sometimes (using non-standard tags or attributes), but for the most part, the editor and the filters are pretty smart.