Modigliani-squared or Bubble-squared?

Just read the latest issue of The Wall Street Journal Europe (dated May 14-16, 2004). Three articles drew my attention. The first one is announced on the front page and pictures the Sage of Omaha, Warren Buffett: "Risky Bet: Is Warren's Buffet's opinion on hedge funds accurate?" The next one is entitled: "Picasso's Painting's Price Is No Measure of Its Worth." The third one is an interesting piece devoted to art as collateral: "As Art Prices Rise, More Collectors Turn Great Works Into Loans."

What's the link if any, between these three seemingly unrelated pieces of news. Well, the point is not that Warren Buffet is rather skeptical about hedge funds (even though you could argue that (re)insurance companies such as the one he runs are sometimes as close as you can get to hedge funds). It is rather the fact that art is now really monetized to the point that it can be used as the one and only collateral to a loan. Robert Frank, Journalist at WSJ, notes that "when it comes to borrowing money, the wealthy have often used their homes, investments and yachts as collateral. Now, they've found a new source of cash: the art on their walls."

For instance, Manhattan-based Art Capital Group (by the way founded by an art dealer and gallery owner) "will take your painting or collectible and give you cash in return, usually up to half the value of the work." The new feature is that this work will serve as the sole collateral to the loan. Even more interesting is the fact that, Citigroup Private Bank, also running the same kind of lending activties, attracts more and more hedge funds managers. These rather wealthy managers (no wonder why says Buffett when you look at the opacity (what an oxymoron!) of their operations and fat fees) put their paintings at stake to run carry trades whereby they fund themselves using their Modigliani or Picasso and invest the proceeds in their supposedly high-yielding hedge funds operations: Borrow at 5% or 6% and invest at 25! Some use the proceeds to buy even more paintings.

In a nutshell, Modigliani-squared! One for Amedeo, one for Franco. Use Amedeo (the famous painter) to raise cash and invest the proceeds to "invalidate" Franco ((defunct) MIT Professor of Economics (Nobel Prize winner) who crafted, along with (defunct) University of Chicago Professor of Finance (also Nobel Prize winner), the Modigliani-Miller (M-M) theorem). The M-M theorem says that you don't change the size of a pizza by the way you cut it. In othet words, a corporation that borrows money does not create value, it just slices its cash-flows differently. Unless, there are some imperfections to be monetized (taxes, information costs, bankruptcy costs etc...), don't expect any miracle.

Here, this wisdom seems to be turned upside down by the Amedeo-Franco combination! Weird indeed! Even more when you think that an art bubble may be in the making: Think of recent auction prices such as Picasso's "Boy With a Pipe". Indeed, what if being able to use art as a collateral, triggers some kind of art speculation (in a nutshell bubble-squared)? You better be the one jumping first out of the boat. It seems that institutions that lend money backed by art collateral are double-betting. In the case where the proceeds are used to buy more art, they bet that this art will fare well financially speaking and in case it does not, they bet that their collateral won't dive too. In case, the proceeds are invested elsewhere, say hedge funds or equities, they bet that, in case these investments don't do well, the art market wont' be hurt too. Otherwise, they'll be killed twice! One by their ailing client and two by the ailing piece of art.

In any case, Peruvian economist Hernando de Soto must find all this ironical. In his famous book The Mistery of Capital, he argues that the lack of clearly defined property rights in poor countries impinges the ability to create collateral and hence the ability to invest. It seems like rich and poor countries drift more and more apart: More wealth creates more collateral opportunities that allow to invest in new projets that will create new collateral and so on and so forth... unless of course the circle turns out not to be virtuous but vicious (bubble-squared) instead.

So, when art meets finance, what do you think, should we expect the best or the worst?