DEFINITION of 'Diversity Score'

The diversity score is a proprietary tool developed by Moody's Investors service that estimates the level of diversification in a portfolio. It was initially created to gauge the relative risk of particular collateralized debt obligations (CDO). As the mortgage CDO market expanded in the early 2000s, though, Moody's couldn't continue as it had. In 2004, the diversity score was abolished under the direction of its credit committee.

Moody's claimed that most CDOs at the time contained RMBS assets and lacked diversity, so it no longer made sense to use the diversity score. By abandoning the score, Moody's caught flak from regulators and the investment community for somewhat encouraging the hazardous behavior that led to the housing market crash. Today, the diversity score is used to assess the conditions of other assets like collateralized loan obligations (CLO). 

BREAKING DOWN 'Diversity Score'

The 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 correlated assets have the same loss distribution as 50 uncorrelated assets. Assets in the same industry are considered identical, and an individual default risk is assigned to each asset in the portfolio. Of course, calculating the exact value is a little more nuanced. 

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, 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.

RELATED TERMS
  1. Cut-Off Score

    A cut-off score is a minimum credit score an individual may have ...
  2. FAKO Score

    A derogatory term for a credit score that is not one of the FICO ...
  3. Business Credit Score

    A number indicating whether a company is a good candidate to ...
  4. Credit Score

    A credit score is a number ranging from 300-850 that depicts ...
  5. Insurance Score

    An insurance score is a rating used by insurance companies that ...
  6. Precision Score

    A number used by the TransUnion Credit Bureau to quantify the ...
Related Articles
  1. Personal Finance

    How High Is a 'Good' Credit Score?

    How high of a credit score do you need to get a home mortgage or buy a car? Read on for some actual numbers.
  2. Personal Finance

    Is My Credit Score Good Enough for a Mortgage?

    Your score is critical in determining not only whether you'll secure a loan for a home, but also what interest rate you will be offered.
  3. Personal Finance

    Credit score ranges: What do they mean?

    Understand what credit scores in each range mean for your future. Learn how to improve your credit score and how it affects your ability to borrow money.
  4. Personal Finance

    Why The Credit Score You Buy Differs From The Lender Score

    It takes many people by surprise when they purchase credit scores and find the lender's credit score disclosure does not match.
  5. Personal Finance

    How Bad Is My Credit Score?

    Find out how to assess your credit score to determine if it's too low or sitting at a comfortable level. Learn how to improve your creditworthiness.
  6. Personal Finance

    The Dirty Secret About Your Credit Score

    The tier system of credit scores leaves borrowers with little wiggle room.
  7. Personal Finance

    Credit Scores And Your Mortgage Payment: It Matters

    Your credit score can have a huge impact on your mortgage payments. Here are some reasons why.
  8. Personal Finance

    Common Things That Improve And Lower Credit Scores

    Credit scores are used by lenders to estimate credit risk. Find out how you can better earn the trust of lenders and reap the benefits.
  9. Personal Finance

    Your Credit Score: More Important Than You Know

    Credit scores affect key aspects of your personal and professional life. Knowing your score and managing your credit input can make a big difference.
  10. Personal Finance

    The Basics of Credit When Starting Out

    For those starting out, it is important to be consistent and responsible in establishing good credit.
RELATED FAQS
  1. Are personal loans bad for your credit score?

    Discover how taking out a personal loan can affect your credit score, and learn how a personal loan can help your overall ... Read Answer >>
  2. What affects my credit score?

    Learn what affects your credit card and how your current balance and credit limit can affect your credit score? Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center