PARADISE ISLAND, Bahamas - At last week's ABS East 2002 conference, panelists were questioning the methods rating agencies used to rate CDOs backed by structured finance collateral, specifically the requirements for collateral diversification.

Anthony Thompson, managing director at Deutsche Bank Securities, pointed out that the recent downgrades in structured finance CDOs were caused by corporate credit problems and not the underlying ABS. Therefore, some panelists concluded that diversification into corporates by managers without core expertise in the sector may not be helpful in the long run.

However, other analysts argued there is no guarantee that collateral performance today is indicative of future performance, and overexposing a deal to assets that are currently performing may be shortsighted. Diversifying slightly into corporates is a good strategy in the long run, as there's no telling what the corporate credit picture will look like in a few years.

Meanwhile, Dan Castro, managing director and head of ABS/CDO research at Merrill Lynch, said that rating agency methodology for rating CDOs is basically flawed.

By taking into account long-term default studies, the rating agencies are not able to consider short-term volatility that is typical of the CDO market place, explained Castro. They also rely a lot on diversification based on economic factors.

Castro argued that there are basically two other types of diversification - geographic, which is used in ABS, and industry, which is used for corporates. He said that industry diversification does not necessarily work for CDOs.

During the panel discussion, David Tesher, head of the CDO group at Standard & Poor's, was in the audience and stood up to counter arguments made against rating agencies at the panel.

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