Art as collateral: an expert view

Janet Tavakoli

According to a recent report in the New York Times, not only are more banks lending against art as collateral; some are even starting to create collateralized debt obligations with art as the underlying asset.

But is this really possible? A collateralized debt obligation is a structured asset-backed security. It pools fixed income securities (for example, mortgages, loans and credit card debt) and repackages these into ‘tranches’ which are sold to investors.

The cash flow these assets generate is paid to investors according to the tranche in which they have invested: the senior tranches are safer for investors and have a higher credit rating; the lower tranches are the first affected if the cash flow proves insufficient to pay all the investors.

It is hard to see how art would fit into this picture.  Art does not supply cash flow, but it could serve as collateral for a loan that could be included in the bundle of fixed income securities pooled in a CDO.

Janet Tavakoli, president of Tavakoli Structured Finance and author of several books on CDOs, says she is unaware of any art CDOs at this time, but she has certainly seen art being used as collateral for loans. Last year, for instance, Goldman Sachs came to the aid of hedge fund manager Stevie Cohen, head of SAC Capital Advisors, with a loan backed by Cohen’s $1 billion art collection.

“The financial market is in a bubble. When financial bubbles burst, art prices plummet. Goldman Sachs is always looking for a way to lay off risk on someone else,” says Tavakoli.

She sees further portents in the behaviour of former SAC employee Adam Sender, who started up his own hedge fund, Exis Capital Management. Last year, having shuttered the fund, he put his art collection up for sale. Sales of the collection, which included pieces by Dan Flavin and Richard Prince, are ongoing at Sotheby’s.

While Tavakoli has not encountered any art CDOs, she agrees that art-securitised loans could make their way into CDOs. This highlights the often unexplored issue of what, precisely, goes into a CDO, and how safe a bet it really is.

“As long as investment banks make collateralized loans, any of those loans—no matter what backs them—can end up in a structured note or a securitization, and if investors aren’t alert, they may find those loans in their portfolios,” she says.

“For example, many of the so-called subprime CDOs had contained slices of other CDOs with odd names. If you examined the collateral of those CDOs, you found student loans, consumer loans, all sorts of loans. Many investors were unaware of the true nature of the loans.”

Tavakoli points out that for a security backed by art loans, the only source of revenue is the payment on the loans, and if the loans go bad, there’s no upside from an increase in the value of the loan, only downside.

“If the loan defaults and you have to liquidate the art, be prepared to find the art collateral hasn’t been properly secured and/or the value isn’t what you hoped it would be. Art is illiquid and subjectively valued. The price discovery is poor. As the saying goes: ‘The price is what the price is, because that’s what the market says it is.’”

Ultimately, the challenges of using art as collateral for a securitized loan are similar to the challenges of art as an investment.

“Art is granular, subjectively valued, a potential target for forgers and fraud, often difficult to store and insure, and there’s no liquid secondary market for many pieces. Investors in a collection are not in a position to place a monetary value on the underlying collateral,” says Tavakoli.

Her perspective is that buying art in the hope of making a profit is speculation, not investment.

But there are other reasons to buy art.

“Art lovers invest in something that appeals to them or that they feel will appeal to their circle of friends and thus enhance their prestige. The latter reason usually doesn’t work as well as the former when it comes to execution.

“Art isn’t a commodity, and it isn’t a necessity. My own point of view is that an investment in art is an investment in one’s own aesthetic. I recall hearing that Frick strolled through his galleries in the middle of the night for the sheer pleasure of it. I never got up in the middle of the night to read a loan document for the fun of it.”