There’s been an awful lot of talk since the crisis about lessons learned, many of them the very hard way in U.S. mortgage finance.  In this bloody arena, the ratings of subprime mortgage-backed securities (MBS) stand out for opprobrium along with those granted by the rating agencies to parent-company issuers with neither capital nor scruple.  As a result, the raft of post-crisis reforms include many designed to ensure that the rating agencies never again look blindly at risk because it’s inconvenient to call attention to it.  There have been many troubling signs that the rating agencies were going back to their lucrative pre-crisis habits, but none is as stark as the case of Canada’s Home Capital.  Eerily echoing all the pre-crisis bad practices, many fear this case could lead to a systemic bust north of the border all too reminiscent of ours a decade ago.  Why are we doing all this all over again?

In short, it’s because ratings make life easier for bankers, regulators, and examiners – even if they’re wrong, at least everyone knows what they are and has a ready defense for all sorts of mistaken judgments.  The putative benefit of ratings is transparency.  The downside of all of this is massive correlation risk that can quickly lead to “cliff effects” – that is, a sudden fall into the systemic abyss created by all of the claims and counter-claims required when ratings plummet.    

Although all of the rules designed to reduce rating dependence have made nary a dent in the global addiction to the agencies, there are several standards designed to cushion bank backsides as ratings suddenly slide downhill.  The rest of the financial system is, though, on its own. 

A cliff effect is exactly what’s happening in Canada to Home Capital.  S&P reduced the company’s ratings from investment grade to junk in two bumpy actions in just six days.  Canada’s banking system stands firm against all the resulting panic runs by depositors and counterparties at Home Capital not only because of the new rules, but also because Home Capital is relatively small.  The rest of Canada’s financial system – where risk is correlated with ratings and real-estate markets are red-hot – is suddenly in precarious territory. 

This of course sounds all too familiar.  Not only does it show that the rating agencies haven’t changed their ways, but it’s also graphic, costly evidence that regulators have neither forced better credit-risk analytics where they can nor insulated financial systems from the devastating risk of boom-bust cycles in residential real estate. 

Time will tell if Canada’s strong financial system stands against Home Capital’s shock.  Time is not, though, on the side of regulators, including in the U.S.  If ratings don’t cause a systemic-scale correlation risk this time around, we’ll just have been lucky.  Next time or the time after that, we won’t be as fortunate as long as ratings are insulated from emerging risk and markets rely on ratings up and down the boom-bust cycle.