Liquid Art

For all that market volatility and attendant risk, the collateralization of art has for some time had its place within wealth management. Florence's Medici family--which used its vast wealth to build a Renaissance-era banking and political dynasty--is purported to have mixed finance and fine art with the same virtuosity that Michelangelo (whom they patronized) mixed oils. Since the 1970s, banks, too, have been extending art-secured funding. More often than not, banks make these loans to customers who already have a tidy sum of wealth under management, thereby cementing ties. With $1 trillion in fine art making its way into private hands in recent years, such credit facilities have become bigger business. In the first half of 2009, according to The Art Newspaper, art-secured loans rose 40%.

There are many reasons for this spike, most of them sound. To start, high-net-worth Americans are less liquid than in downturns past. Their increased reliance on variable income streams, which aren't yielding nearly the cash they once did, is largely to blame. This was borne out by a survey earlier this year of those earning $250,000-plus annually. Unity Marketing, a market research firm in Stevens, Pennsylvania, found 39% of respondents had bonuses or commissions cut. Twenty-nine percent also reported regular income had shrunk, and three in five said their overall financial situation had worsened. If you're asset-rich but cash light, temporarily extracting capital from art can look like a good stopgap, especially as the costs of traditional borrowing rise for even the most creditworthy. Furthering the appeal is that collateralized art typically remains with the borrower. There, it can continue to be enjoyed even as up to 50% of its lowest appraisal value is liquefied.

Today, a borrower may also want extra cash to opportunistically reposition for recovery. If he owns a business, leverage supplied by fine art can help to fund the purchase of a rival company at buyer's-market terms, or to capitalize a retooling of operations in advance of a turnaround. As likely, the liquidity may satisfy short-term needs as a collector awaits the sale of a home or business. But the rationale could be simpler. Where divorce is imminent, collateralizing may make sense while awaiting a collection's auction or private sale. There may also be tax implications that entice a collector to delay a sale until the next calendar year while accessing half the art's value through an interim loan. Most plausible, an avid collector may want to leverage a high-value work to fund the acquisition of complementary pieces.

Even if a collector owns investment-grade works that may have held value for hundreds of years--or are in a category that has weathered several recent recessions well--there are situations where collateralizing is unwise. One such situation is a collector seeking to feed an art-buying appetite that's begun to outstrip even his considerable means. Piling onto an already excessive personal debt load is another similar situation. Rather than borrow at what could prove live-to-lose-another-day terms, collectors should weigh selling pieces, and/or reaping the tax benefits of "gifting." There's no one-size-fits-all formula for deciding whether or when to collateralize, sell or gift. That's why the decision should be made only in counsel with expert legal and financial advisers who can balance advantages and drawbacks of each option.

No matter if a client sells, gifts or collateralizes, any risk-abating strategy must begin with a more accurate valuation of a collection's market value. Here, the experience of Emigrant Fine Art Finance, a provider of loans ranging from $1 million to $100 million, proves illuminating. Based on a review of its loan applications, the company estimates at least half of would-be borrowers initially underestimate the value of the art they're thinking of using as collateral.

Notably, even if an appraiser overshoots a valuation slightly--or secured works fall in price 10% to 30% soon thereafter--lenders can remain confident the borrower will strive to repay. (Remember, these are loans that, by the most aggressive valuations, likely began with 50/50 debt-to-equity ratios.) Where problems can arise for both lender and borrower is if the secured art is lost, stolen or damaged. In anticipation of any of those possible events, both parties must give extraordinary thought to how secured works are protected and insured. If the borrower retains possession of works, the lender should take extra care to see that the right policy, safety and security precautions are in place. And if the lender is in possession, the same holds true for the borrower. With that higher standard of vigilance in mind, the following three rules should be followed without fail.

Have a firm sense of total worth, past, present and future. When collateralizing, the credit facility is almost never secured by a single work. To be prudent, the bulk of the secured folio should be pieces that have historically held stable in value or appreciated predictably over the long term. The balance of collateral could consist of works that are undervalued by present market standards, and would, thus, offer more valuation upside than down over the life of the loan. Borrowers should steer clear of leveraging art that's in-demand now, but, absent any track record, could see big near-term valuation swings as critics and collectors deliberate whether its popularity will stand the test of time. Diversity (in terms of genre, artist, and maybe even the lending terms and conditions attached to different subsets of secured works) is the watchword. Borrowers should have a good fix on the total value of their collateralized art. A reputable lender will share this concern for accurate, active, aggregate valuation.

Know where it is and/or where it's going. The borrower should always know exactly where their collateralized inventory is being displayed or stored. That's the case regardless of who (owner or lender) is holding onto the works during the financing term. A large component of shielding these works from harm centers on understanding the physical threats presented by the environment they're in. As a courtesy, some insurers will offer access to risk specialists who will visit a display or storage site and directly assess unique environmental issues. They can also advise on proper packing and transport if art must be relocated.

Protect it from safety and security threats. Moisture, extreme temperatures and UV rays are among the biggest physical concerns. That said, collectors, or those holding their art, should avoid basement and attic storage. Where some sunlight is desired, windows should be treated to block harsh rays. Even how a work is framed and hung can put it at risk of damage. So trust those presentation matters only to qualified specialists. Proper wrapping and climate-controlled storage--ideally in a specially designed closet--is also advisable. Finally, given that there's some $6 billion in stolen art placed on the market each year, owners should make every effort to acquire clear title, and to rely on security experts to protect art from theft.

Perhaps the best counsel a wealth manager can give to a client who's considering the merits of collateralizing art comes inadvertently from Leonardo da Vinci. "One can have no smaller or greater mastery," he observed, "than mastery of oneself." What's demanded is an active, in-control ownership--a self-mastery--of valuations and risks, small and great. Anything less is a paint-by-numbers exercise that leaves borrowers and lenders with less of their favorite color: green.

Andrew McElwee is executive vice president of Chubb & Son and chief operating officer of Chubb Personal Insurance. He can be reached at amcelwee@chubb.com
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