It sounded to me like the "real" models are layered 3-D wireframes - 1 for the body, and 1 for the "clothing", and that a mod could change the opacity of the clothing layer. I understand this was done also in The Sims 2 - although hackers added shading for the areolas to complete the effect.
I think the change to "M" rating was done because too many people in the USA are too sensitive to this, and somehow think that "technically possible" = "accidentally likely". They tried to deflect from the political nature of this decision by saying something like, "oh yeah, and on second thought it's more violent than we thought too...".
The really odd thing to me though, is how violence is often deemed less serious than sex in the USA. It completely baffles me.
One "letter to the editor" of a web news service I often read, states it plainly when referring to the story:
http://www.theinquirer.net/?article=31454 (about halfway down the page)
"Subject: Elder Scrolls Oblivion mod makes girls' tops fall off
I really have to laugh. Think about what tits are for, and then explain to me how the sight of them is harmful to children.
Jude Suszko"