Decreasing diversity in the loans underlying commercial mortgage backed securities (CMBS) could increase the volatility of CMBS tranches unless offset by additional credit enhancement, says Moody’s Investors Service in a new report. “In the present liquidity crunch, concentration among the loans securitized by CMBS is an increasingly important issue,” said Tad Philipp, author and managing director at Moody’s. One of the ways a rating agency measures diversity is the Herfindahl score, usually referred to as “Herf.” Moody’s calculates a securitization’s Herf score by using an equation that converts pools of loans of unequal size into a simulated number of equal-sized loans. Loan pools with a high Herf score indicate less loan concentration, while pools with a low Herf score exhibit higher loan concentration. The diversity in commercial mortgage loan pools as measured by the average Herf score has fallen from a credit-neutral 100 in the late 1990’s to just 40 in the third quarter of 2007, says Moody’s. The decreasing diversity means that the average commercial loan balance in recent deals equals 2.5% of the pool; Moody’s rating methodology requires additional credit enhancement for CMBS made up of such concentrated pools. “CMBS deals are on the frontier of where loan diversity becomes a significant credit issue. Tools like the Herf score help Moody’s differentiate the diversity profile of deals, which is an important step toward seeing that they are properly enhanced,” said Philipp. The report, “US CMBS: Conduit Loan Diversity–Why the Herfindahl Score Matters,” is available at http://www.moodys.com.