What Is a Diversity Score?
The diversity score is a proprietary tool developed by Moody's Investors Service that estimates the level of diversification in a portfolio containing alternative assets. In particular, it was initially created to gauge the relative risk of particular collateralized debt obligations (CDOs).
As the mortgage CDO market expanded in the early 2000s, however, Moody's could no longer continue to trust the scoring algorithm and so the diversity score was modified under the direction of its credit committee.
- Moody's Diversity Score is a measure to estimate the diversification in a portfolio that considers the issuer and industry concentrations in the actual portfolio and incorporates assumptions on default correlations.
- The Diversity Score is obtained from the CDO's monthly surveillance reports, measuring the number of uncorrelated and identical assets that would have a similar loss distribution the actual portfolio of correlated assets.
- As correlations between CDOs in the marketplace grew, the scoring algorithm had to be modified, with its 2009 revision resulting in far greater complexity and nuance following the 2008 financial crisis.
Diversity Scores Explained
The Moody's Diversity Score measures the number of uncorrelated assets that would have the same loss distribution as the actual portfolio of correlated assets. For example, if a portfolio of 100 assets had a diversification score of 50, this means the 100 assets held would actually only have the same loss distribution as 50 uncorrelated assets. Assets in the same industry or from the same issuer are considered identical, and an individual default risk is assigned to each asset in the portfolio. Of course, calculating the exact value is a a bit more nuanced.
In the 2000s, Moody's observed that most CDOs at the time contained RMBS assets and as a result lacked diversity, so it no longer made sense to use the diversity score. By abandoning the score, however, Moody's caught flak from regulators and the investment community for somewhat encouraging the hazardous behavior that led to the subsequent housing market crash and credit bubble.
Today, the diversity score is used to assess the conditions of other assets like collateralized loan obligations (CLO). Theoretically, CLOs with a high diversity score are shielded from the ups and downs of the market because not everything in the pool of loans is exposed to the same conditions. This means the likelihood of the entire portfolio faltering is smaller than if it exhibited a high correlation.
Changes Made to the 'Diversity Score'
In 2009 following the burst of the CDO bubble and the resulting financial crisis, Moody's made significant changes to its calculation of the diversity score. Greater complexity and interdependence of the credit markets placed a huge burden on many regions, industries and economies around the world. Each factor led to a sharp increase in observed default correlation among corporate credit, which pushed Moody's to create a more realistic score that reflected the changing market environment. The new methodology updated some key parameters of the existing model used to rate and monitor CLOs.
Limitations of the Diversity Score
Some analysts claim the diversity score is an imperfect measure of risk. It does not consider how industries within a portfolio pool may be linked. For example, a CLO consisting of loans to a trucking group and petroleum producer is considered well-diversified, but in reality, the price of gas also impacts the trucking industry. Others suggest that the score overestimates default probabilities and correlation and doesn't give enough weight to recovery rates after default.