Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown, and How to Fix it

Abstract

This article analyzes the current global financial crisis not, as the Treasury and others would have it, as a failure in institutional regulation, but as a failure in securities regulation. The reason why major financial institutions lost trust in each other was not so much because they were badly regulated, but because they were holding trillions of dollars in nominal value of securities that, despite their investment grade ratings, were worthless, or could not be valued at all. The reason for this is that the collateralized debt obligations in this class were based on asset-backed securities that, under inadequate SEC rules such as Regulation AB and preceding rules, were not subject to the kind of due diligence concerning their underlying assets as more conventional debt. The problem was compounded when the asset-backed securities were used to construct complex derivatives, which relied solely on ratings by credit rating agencies such as Standard & Poor's and Moody's, which were not required to review the documentation of the securities that they rated and which were in fact subject to severe conflicts of interest, since they were paid by the issuers for investment-grade ratings. Their ratings therefore did not accurately reflect the ability of CDOs to pay principal and interest, and in fact the agencies went into an orgy of rerating asset-backed securities when the housing bubble began to break with the collapse of the subprime mortgage market in 2006. This article proposes several responses to these problems, centered on broadening the application of the securities laws to included the rating process. It analyzes why the Credit Rating Agency Reform Act of 2006 ("CRARA") failed to meaningfully reform the rating system, and in fact proved counterproductive. New regulations proposed by the SEC, because they are limited by provisions in CRARA that bar the SEC from interfering with the rating process, are foredoomed to failure. Only legislation that brings the rating agencies fully within the due diligence requirements of securities law, along lines similar to those which brought underwriters under the aegis of the Securities Act of 1933, will assure that ratings will convey accurate, timely, and meaningful information to the markets, permitting more realistic valuation of complex securities in the future.