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.
Despite disagreement about the ultimate causes of the financial crisis of 2008, observers agree that inflated credit ratings assigned to the complex structured finance securities known as collateralized debt obligations or "CDOs" were a central cause of the crisis and the severe recession that followed.1 Among the causes identified are a worldwide savings glut, the increase in systemic risk resulting from the growth of the largely unregulated shadow banking system, abnormally low interest rates in the wake of the 2001-2002 recession, the inability of Americans to afford homes in an environment of stagnant wages and rising real estate prices, subprime mortgages and the proliferation of CDOs, credit default swaps ("CDSs") and other new financial instruments. CDOs occupy a central place on this list, because they were the channel through which a flood of investment capital inflated the American housing market, thereby linking many of the other causes together.2 Unfortunately for investors, homeowners and taxpayers the complexity inherent in the typical CDO gave rise to massive informational failures that remained hidden while the real estate market continued its rise. These failures manifested themselves primarily in the investment grade ratings the majority of CDO securities received. After the U.S. real estate market peaked in 2006, CDO securities suffered unprecedented ratings downgrades in 2007 and 2008, ushering in the credit crisis of 2008 and the ensuing recession.3
A central objective therefore of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act")4 is to prevent the credit rating agencies ("CRAs") from issuing such inaccurate ratings in the future. To accomplish this, Subtitle C of Title IX of the Dodd-Frank Act, "Improvements to the Regulation of Credit Ratings Agencies" ("IRCRA"), extends the traditional American securities law strategy of mandatory information disclosure to the credit ratings process and institutes corporate governance rules meant to curb the influence of conflicts of interest. It also exposes the CRAs to standards of liability similar, though not identical, to those other experts who opine on securities offerings face, and begins the process of eliminating the NRSRO (Nationally Recognized Statistical Ratings Organization) designation from federal law. …