The pros and cons of CDO diversification has attracted a lot of attention.

In his opening comments at the Bond Market Association's CDO conference last month, Merrill Lynch's Chris Ricciardi noted diversification had offered little in the way of stability for collateralized debt obligations. Prevailing market theory has followed the don't-put-all-your-eggs-in-one-basket approach, believing that a well-diversified structure would help mitigate downgrades. In the wake of record-breaking downgrades over the last 24 months, Ricciardi stated the CDO diversification play was essentially dead.

Several CDO gurus took that baton and ran with it during a panel discussion at the ABS East conference this month. At an investor/issuer roundtable, several comments developed along the lines that diversification does not necessarily reduce risk if it causes CDO managers to invest in asset classes one does not have expertise in. Another participant noted it was important to explore the level of resources a CDO manager can devote to the asset classes that are bought.

Morgan Stanley weighed in on the topic last week. In a recent research piece Diversity Perversity, analyst Kenneth Lee looked at the effects of a higher diversity score on ABS CDOs.

According to his research, boosting diversity scores simply to get thinner enhancement levels can actually backfire as it could end up in more downgrades. For example, Lee found deals in the 1999-2001 vintage with low diversity scores experienced fewer downgrades than those with high diversity scores. Furthermore, deals with low diversity scores but strong underlying assets and extra credit enhancement offer relative value to those with less enhancement and higher diversity scores.

"The high diversity score deals have an average asset notch displacement of -1.5, compared to only -0.8 for low diversity score deals, or approximately half the rating migrations of those with high diversity scores," Lee detailed in the report. WARFs of the low diversity score deals did not migrate more than one rating category. This compared to one-and-a-half rating categories for high diversity score deals.

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