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.