01/13/2012 03:37 pm ET Updated Mar 14, 2012

Downgrading the Big Three

Since August, when Standard and Poor's cut its ratings for America's debt, stock markets have swung wildly on news that one country or another faced a similar downgrade. Many investors cowered on the sidelines as rating agencies issued warnings. But while ominous news reports spooked traders, the rates paid on U.S. Treasury bonds actually declined when a ratings downgrade should have forced them upward.

The public may be puzzled to see that countries on the downgrade watch-list may actually pay less to borrow. However, experienced investors know that the market has adopted a new attitude about the once venerable ratings agencies that grade debt issued by corporations and governments. Indeed, Standard and Poor's, Moody's, and Fitch -- also known as The Big Three -- lost much of their credibility as they failed to act as reliable brokers of information and played a big part in creating the economic crisis that began in 2007. In effect, the market has downgraded them.

I first discovered the flaws in the ratings system in the spring of 2006, when I began examining the pools of mortgages offered to investors by many major banks. The Big Three had judged these instruments to be safe, investment grade bonds and given them their approval. But anyone who took the time to review the underlying loans could see they were full of problems. In many of the pools, which were rated investment grade by all three agencies, 70 percent of the mortgages were interest-only notes that would require a doubling of payments in just two years. A homeowner who could barely afford a $1,000 a month- - and wouldn't qualify if forced to show his true financial condition -- would suddenly be required to pay $2,000. Anyone could see that securities backed by these kinds of loans would fail when their teaser interest rates went up three percent and the principal and the interest-only feature was eliminated at the same time.

The mortgages that were about to re-set ticked like a time bomb inside a real estate bubble that had been growing since the year 2000. In that time investors had poured hundreds of billions of dollars into these mortgage loan pools, mainly on the basis of the high ratings they received from The Big Three. All this money made it easy for lenders to keep offering loans to borrowers who weren't required to prove their income or assets. The easy money, which significantly lowered the monthly cost of buying a home, helped further inflate real estate values as millions of people who were not genuinely qualified, became proud but over-extended homeowners.

The bubble was there for all to see. Indeed, many individuals and institutions examined the mortgage market and concluded, as I did, that The Big Three, who were supposed to act like the cop on the beat, had failed. The securities underlying the housing bubble were fatally flawed. When it finally burst, the small number of us who called the market correctly, profited. Those who had trusted the rating agencies suffered enormous losses. Worse still, the collapse in real estate brought down the rest of the economy, giving us the worst crisis since the Great Depression.

In the aftermath of the meltdown, it's plain to see that most of the individual players acted as they were supposed to act in a free market. Renters became owners when offered cheap mortgages. Lenders kept issuing loans because investors kept funding securitized mortgages. Investors acted on the basis on the high grades granted to these mortgage securities because they didn't understand that the rules of rating had changed. To understand how, you have to go back to when the longstanding relationship between The Big Three and the market was radically reformed.

In the early 1970s a variety of reasons led the big rating agencies to stop charging investors for their services and begin billing those who wanted their stamp of approval. Since Moody's, Fitch, and S&P charged roughly the same price, they competed mainly on the basis of providing good service. Good service meant maintaining good relations with the corporations and public debtors they reviewed. At the same time everyone issuing debt was essentially "paying to play" as they wrote checks to agencies certifying their quality.

Once debtors began paying the bills, ratings underwent a gradual kind of grade inflation as AAA, and AA, became the equivalent of "gentleman's Cs" in the Ivy League of old. I think most investors failed to take this change into account and continued to rely on The Big Three as if they had maintained their independence. They got one wake-up call in the 1990s when Orange County, California was rated AA on the eve of going bankrupt. Another came in 2001 as Standard and Poor's judged Enron to be "stable" until about a month before it filed for Chapter 11.

Now, after the catastrophe of 2007, we should all see that the ratings system is fatally flawed. I won't say that the individuals working in it are corrupt. But we shouldn't deny that over time, the competition for clients and dependency on their payments invariably bred a familiarity that clouded the process of analysis. If Orange Country and Enron didn't teach us this lesson, surely the great recession has.

Today, as the ratings agencies eyeball sovereign debt, they seem determined to make up for their past mistakes by erring in the opposite direction. In downgrading the United States last August, S&P had to ignore America's standing as the world's leading national economy with an unbroken, centuries-old record of honoring its debt. While we may have big trade deficits and debt right now, nothing fundamental has changed in a way that justified the August downgrade. This is why S&P's action did not lead to a flight from U.S. Treasury issues but a decline in the rating agency's reputation, as investors questioned the motivation behind the downgrade.

Going forward, investors must be less dependent on ratings and The Big Three and rely more on their own due diligence. Fortunately, the abundance of public data available makes it possible for us to conduct this research and make our decisions independently. A rating from Fitch, Moody's, or S&P may be factored into our ultimate buy-or-sell choices, but the days when those grades are the main determining factor are over.