Fordham Journal of Corporate & Financial Law Volume 17 Issue 3 Article 2 2012 Informational Failures In Structured Finance And Dodd-Frank’s “Improvements To The Regulation Of Credit Rating Agencies” Steven McNamara Follow this and additional works at: https://ir.lawnet.fordham.edu/jcfl Part of the Securities Law Commons Recommended Citation Steven McNamara, Informational Failures In Structured Finance And Dodd-Frank’s “Improvements To The Regulation Of Credit Rating Agencies”, 17 Fordham J. Corp. & Fin. L. 665 (2012). Available at: https://ir.lawnet.fordham.edu/jcfl/vol17/iss3/2 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Journal of Corporate & Financial Law by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. Informational Failures In Structured Finance And Dodd-Frank’s “Improvements To The Regulation Of Credit Rating Agencies” Cover Page Footnote Assistant Professor, Business Law, Olayan School of Business, the American University of Beirut; B.A., St. John’s College; Ph.D., Boston College; J.D., Columbia University School of Law. The author may be contacted at [email protected]. He wishes to thank his colleagues Ali Termos and Neil Yorke-Smith for comments and discussion during the course of preparation of this article. This article is available in Fordham Journal of Corporate & Financial Law: https://ir.lawnet.fordham.edu/jcfl/vol17/ iss3/2 VOLUME XVII 2012 NUMBER 2 FORDHAM JOURNAL OF CORPORATE & FINANCIAL LAW INFORMATIONAL FAILURES IN STRUCTURED FINANCE AND DODD-FRANK’S “IMPROVEMENTS TO THE REGULATION OF CREDIT RATING AGENCIES” Steven McNamara INFORMATIONAL FAILURES IN STRUCTURED FINANCE AND DODD-FRANK’S “IMPROVEMENTS TO THE REGULATION OF CREDIT RATING AGENCIES” Steven McNamara* ABSTRACT 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. * Assistant Professor, Business Law, Olayan School of Business, the American University of Beirut; B.A., St. John’s College; Ph.D., Boston College; J.D., Columbia University School of Law. The author may be contacted at [email protected]. He wishes to thank his colleagues Ali Termos and Neil Yorke-Smith for comments and discussion during the course of preparation of this article. 665 666 FORDHAM JOURNAL [Vol. XVII OF CORPORATE & FINANCIAL LAW TABLE OF CONTENTS INTRODUCTION .................................................................................... 667 I. INFORMATIONAL FLAWS INHERENT IN COLLATERALIZED DEBT OBLIGATIONS ...................................... 669 A. THE HOUSING BUBBLE AND THE RISE OF STRUCTURED FINANCE ................................................................................. 670 B. OVERVIEW OF THE COLLATERALIZED DEBT OBLIGATION ......... 676 C. INFORMATIONAL FLAWS ........................................................... 680 1. Risky Collateral ............................................................... 682 2. Ratings Models ............................................................... 685 3. Compounding Errors ...................................................... 693 D. RATINGS MODELS AS THE PRIMARY CAUSE OF FLAWED RATINGS ................................................................................. 694 1. Collateral Quality ............................................................ 698 2. Faulty Correlation Figures .............................................. 699 3. Ratings Arbitrage ............................................................. 701 E. THE IMPLICATIONS OF CDOS AS INHERENTLY FLAWED ............ 707 1. Theoretical Implication: Real Estate-Backed CDOs as “Lemons in Disguise” ...................................... 709 2. Practical Implication: The Current Market for Structured Finance Securities .................................... 716 II. THE RESPONSE: “IMPROVEMENTS TO THE REGULATION OF CREDIT RATING AGENCIES” ............................ 720 A. MANAGEMENT OF CONFLICTS OF INTEREST .............................. 723 B. NEW DISCLOSURE REQUIREMENTS ........................................... 727 1. Office of Credit Ratings Annual Reports on NRSROs ..... 727 2. Transparency of Ratings Performance ............................ 728 3. Disclosure of Changes in Ratings Methodologies ........... 728 4. Transparency of Credit Ratings Methodologies and Information Reviewed ...................... 729 C. THE LITIGATION LANDSCAPE .................................................... 731 1. The Pre-Existing Legal Framework ................................ 732 2. Increased Exposure to Litigation Risk? ........................... 738 D. IRCRA AS A RESPONSE TO INFORMATIONAL FAILURE ............. 742 1. IRCRA and the Technical Failures of the Ratings Process ............................................................................. 742 2. The Nature of IRCRA’s Response to Informational Failure ............................................................................. 746 CONCLUSION ........................................................................................ 749 2012] INFORMATIONAL FAILURES 667 IN STRUCTURED FINANCE INTRODUCTION 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 1. See FINANCIAL CRISIS INQUIRY COMM’N, FINANCIAL CRISIS INQUIRY REPORT (2011) [hereinafter the “FCIC REPORT”] (typifying the disagreement over the ultimate causes of the financial crisis, see the majority report and dissents. The report by the majority focuses on misdeeds and failures at the Wall Street investment banks and the CRAs, while the minority dissent focuses on a global credit bubble, among other causes; a second dissent focuses on government housing policy). 2. See generally Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007-2008, 23 J. ECON. PERSPS. 77, 98 (2009) (concluding that “[w]hat is new about this crisis is the extent of securitization, which led to an opaque web of interconnected obligations.”); GARY B. GORTON, SLAPPED BY THE INVISIBLE HAND: THE PANIC OF 2007 61-113 (Oxford Univ. Press 2010) [hereinafter GORTON, SLAPPED BY THE INVISIBLE HAND]. 3. See Emphraim Benmelech & Jennifer Dlugosz, The Credit Rating Crisis (NBER Working Paper No. 15045), available at http://www.nber.org/papers/w150 45.pdf (Table 2: Structured Finance Upgrades and Downgrades; Table 5: Asset Types with Most Downgrades). 668 FORDHAM JOURNAL [Vol.