Informational Failures in Structured Finance and Dodd-Frank's 'Improvements to the Regulation of Credit Rating Agencies'

This article analyzes the credit rating agency reform provisions of the Dodd-Frank Act's “Improvements to the Regulation of Credit Rating Agencies” in light of the massive failures in the ratings of structured finance securities leading up to the 2008 credit crisis. The primary cause of ratings failure was the flawed quantitative ratings models used by the rating agencies; conflicted behavior on the part of the rating agencies was also an important but secondary cause. The key mechanical flaw in the ratings models was the method used to determine correlation, a measure of the likelihood that one borrower would default in the event that another did. In addition to flawed correlation measures, other important causes of informational failure in real estate-backed collateralized debt obligations include the decline in collateral quality at the peak of the housing boom and ratings arbitrage on the part of investment banks sponsoring structured finance transactions. While the Dodd-Frank Act contains important reforms meant to reduce the likelihood of future ratings failure, it does not attempt to regulate the ratings process directly but instead relies on the traditional securities law strategies of disclosure and liability to incentivize the production of accurate ratings. Such an indirect approach may be both puzzling and disappointing to critics of the rating agencies. It does however reflect the prevailing rule that the SEC may not regulate the substance of credit ratings and the practical limitations of legislators and regulators in this hypercomplex area, as well as a psychological aversion on the part of legislators and the public to understanding a central cause of the credit crisis as a primarily mechanical failure