Investment, leverage effect, liquid assets… Here’s the latest trend in the world of finance: the granting of loans using artworks as collateral. We examine this new practice, born from a simple observation. Art is now an asset: a big one.
The practice of borrowing money using art as a guarantee is not a particularly new one. Back in 1990, the Wildenstein family presented to the world The Lute Player, a misattributed work discovered to be a Caravaggio, and subsequently sent it to the Metropolitan Museum in New York. Recent findings during the family’s trial revealed that the work was also used as a guarantee for a loan: a big one considering the 100 million-dollar valuation. This financial tool, available to the Wildensteins because of the family’s unquestionable fortune, is now available to smaller collectors.
While the practice is not a new one, it has only been in the last 5 years that it has become widespread in the art-banking world. It is estimated that there are between 15 and 20 billion dollars in outstanding loans (the sum of the value of all artworks currently backing loans). The structure of the deal is very simple: collectors offer an artwork in exchange of a loan with lower interest rates, based on the price of the piece, for a predetermined period. At the end of the tenure, the client gives the money back to the institution. What makes the system different from a pawnshop, apart from the big values, is the fact that clients pay interest for the loans, a small value every month. Depending on the structure of the deal, the artworks offered as collateral can stay with the collector during the period or not. There are 3 types of institutions that provide this service: big banks, boutique lenders and auction houses. Any wealth-management office from a big bank will provide the service – either directly or through a third-party lender.
Growing demand and growth
From those billions in outstanding art loans, more than 80% is in the hands of banks. While the loaned value is small compared to the total value of artworks available for sale in the art world, the market for this type of transaction saw double-figure growth in the last 5 years, going from something only offered to premium clients, like the Wildensteins, to almost any collector. Some auction houses offer loans for values as low as 40,000 dollars to known clients.
While other potentially less expensive assets such as jewellery have been lent against money for decades, artworks are surprisingly something new. The reason is rooted in the particularities of art as an asset and the art world’s peculiar structure. First and most importantly, the subjective valuation of art makes it hard for banks and clients to agree on a value. The illiquidity of the art market is also a problem. If the client fails to repay the loan at the end of the period, the lender can seize the possession and sell it. Putting the work up for auction can take time, be costly and fail to reach a minimum value. This makes it harder to assess the risk of the operation – something vital to the credit business. The advent of auction-price databases and increased transparency in art transactions has helped borrowers and lenders find a common ground for valuations, diminishing the problem. As for defaults, they seem to be less frequent than in other asset categories.
One of the main players in the Art Loaning business is Andrea Danese, CEO of the boutique lender Athena Art Finance. When asked about the difficulty of assessing the risk of the operation, he answered: “Valuation of artwork is always a challenging topic. We focus on the high end and more liquid segment of the market and only accept as collateral artists that have a proven history in the market and especially in the auction market”.
Pressure from the clients has also helped to find solutions for the problems posed by banks and was the main factor behind the recent rise of the practice. According to Mr Danese, the emergence of the acknowledgement of art as an asset has sparked an interest in collectors: “Growth in the art lending industry has been driven by the recognition that art is now a meaningful asset on people’s balance sheets and that there are large amounts of liquidity locked in art works that can be freed up and reinvested.”
Regulation makes it easier for American collectors
While the practice has seen an increase in European countries, the bulk of activity is in the United States. The reason is very simple; according to the Uniform Commercial Code, which regulates the conditions for American financial operations, collectors who offer their loans as collateral can keep them. This makes sense, since we don’t need to vacate an apartment to use it as collateral. It only contributes to show how artworks can be compared to any other asset in a financial context. The same is not possible in Europe, making art loaning much more difficult. But not only do regulatory restraints slow down the market in Europe, many older collectors also assimilate the idea of the loan to a pawn, which has a negative connotation for families who lost their possessions after the Second World War. It’s even reported that European banks advise clients who possess properties in the United States to send their works there, so they can structure the loan agreement.
This year (2016), some art financiers have been making efforts to extend the service to China and other Asian countries. Philip Hoffman, art advisor and CEO of The Fine Art Group, the longest-standing art hedge fund in the market, started offering art loans to known clients last year and recently announced the plan to extend the business to Chinese collectors. Back from a trip to the country and convinced of the business potential, he offered a comment on how they would cope with Chinese regulation regarding the possibility of keeping the artworks. “We will take possession of the art collateral at one of our storage facilities in Hong Kong, Singapore, New York, London and Geneva, rather than leaving it with the borrower. We are primarily focusing on Western art, which Chinese buyers frequently source in the US, London or Hong Kong as opposed to China. We will not be storing any art collateral in China.”
The future of art-related financial products
Since the beginning of the 21st century, the finance world has been trying to find ways to design financial products with art as an underlying asset. While mixing artworks and complex investment structures might seem blasphemous from an artistic point of view, it is actually something very natural to bankers. Collectors are, by nature, individuals who posses enough wealth to be able to spend a part of it in artworks. The financial market is one of the most financially rewarding businesses to work, therefore birthing a lot of collectors. Steven Cohen, one of the world’s most notable collectors, has the same superstar status in both the art and the hedge-fund cosmos.
Additionally, the financial market manages the wealth of people who became rich in other industries, and is therefore responsible for making different investment products. The rise of art hedge funds was backed in this principle. In the 2000’s many wealth managers offered returns upon investing on funds composed by artworks. For many reasons, the majority of such funds came to an end in the subsequent years. It made bankers scratch their heads, asking themselves the best way to explore this potential market. Art loans became officially the next big thing albeit the problems in valuations and liquidation. The interest from clients was so big that the industry grew, more “forced” by collectors than the will of money managers.
But if collectors are rich people, why would they need to loan their prized paintings in exchange of cash? The fact is, being rich doesn’t mean having a lot of money available at hand; it can be immobilized in long-term investments or properties. Also, dealers and galleries who have a large stock of paintings can use the service to keep their balance sheets in the positive while going through tougher months, as Mr Danese explains: “The nature of our borrowers spans from collectors to dealers to art funds. An art loan uses exclusively the art as collateral, insulates the borrower balance sheet from any risk in case of default, and truly leverages an asset that otherwise would not produce any real recurring income. Loan proceeds are used by dealers to support the operating costs of their business and finance transactions.”
The dark side of art loans
While art loans are definitely the future of art-related financial products, some aspects of them continue to generate certain questions that bankers might not be willing to answer. From a financial-product perspective, the best way to make an art loan would be to structure something called Asset-Backed Securities or “ABS” in the financial jargon. The problem is that structuring an ABS goes through much tougher financial regulations and banks can’t sell ABS’s to everyone, according to the law. To be eligible for an ABS, the client must go through a process known as KYC or “Know Your Client”, a mini investigation into the investor’s finances to see if he can take the risk of the operation and if his wealth is not involved in anything illegal. Art loans do not need to go through such process. But while the easing of borrowing conditions makes it easier for the average collector to raise money, it also opens the door for people looking for tax loopholes or money-laundering options. This makes the providers of loans engage in a practice known as “shadow banking”. Even if art loans were not designed to serve as a vessel for shadow banking, unfortunately the presence of unscrupulous investment collectors in the art world is undeniable. Banks, boutique lenders and auction houses will not and should not stop making art loans because of a few individuals but this reality does call for stricter regulation of the process.
Another question raised by market spectators was the potential leveraging of the art market. If art-market economists agree that there is no bubble in the contemporary-art market, one of the main reasons for this is its lack of leverage. Art loans are the first tool available to leverage artworks, which means the creation of more value for the art market than the artwork is really worth. In itself, this is not a problem: almost all other markets in the world have some degree of leverage, but excess of it can be disruptive. Yet this process only occurs if owners of borrowed paintings use money to buy more and more art – something that does not tally with the reasons why collectors seek art loans in first place. When asked about the risks of leveraging the art market, Philip Hoffman commented: “Allowing owners of high-quality works of art to release up to 50% of the equity, valued conservatively, from their pictures merely provides such owners with additional liquidity which they may choose to spend on more art or, frequently, something completely different. It is difficult to see how this can harm the art market, arguably it is helpful.”
It is indeed helpful for collectors, and the risk of creating artificial value via falsely inflating works bought on art credit is a small one compared to the pros offered. Art loans are the future of art financing and, more importantly, are making artworks indirectly support traditional business in need of short-term cash. But we must still be vigilant when it comes to artificial inflation of prices or tax evasion in the art world. The art market is too big to do without proper regulation and small disruptions can have a butterfly effect. The antidote against this is the spreading of knowledge and information – something not innate in this business but increasingly necessary.