Lending practices against intangible collateral is an interesting subject to look into. On the one hand, I’ve encountered situations where a bank will refuse to lend against one perfectly maintained luxury vehicle because it is 8 years old, but then go ahead and lend against another similar luxury car that is in much worse condition, solely because it is within 7 years of age. From there, everything from appraised collector’s items to wine collections have been occasionally borrowed against from banks that one would think has no business engaging in such a line of business.
However, next to luxury cars, art proves to be the next common intangible item that a bank will lend against, and at particularly formalized rates. That being said, how is it that a bank can determine the real value of art as a piece of collateral if it’s really just a piece of canvas and some oil paint at the end of the day? Despite having a limited salability, extremely volatile price points, and a notoriously fickle market that can take years to muster, banks have managed to establish a pretty effective system for lending against fine art.
French Impressionist paintings represent the most liquid, and therefore the most reliably priced art-work on the markets today. While individual pieces are auctioned off for tens of millions of dollars at a time, determining the value of an individual piece is still as difficult as always, due to the way in which such a financing arrangement is essentially an unsecured agreement. That being said, the norm habits of banks create a surprising level of consistency in the arrangement. Banks will often lend between 40-60% of the purchase price as being a secured loan for a work, and will provide reasonably low interest rates on the transactions because of their sheer size.
This means that a buyer can actually get a better interest rate on their million dollar painting than they can their car, simply because the banks like the risk profiles of the transaction. But how can they afford to conduct such a risky deal, when default rates are dangerously high? Historically, these loans have shown a 10-40% rate of default, which has required the bank to repossess paintings, and resell them on a rushed auction at well below the asset’s actual value! The answer lies in portfolio theory, and the way in which the banks make a profit by repossessing and reselling the painting upon a client’s default.
In the event that a borrower pays of the entirety of a loan against a work of art, a lender earns their interest return and is happy that they didn’t need to take on any undue stress to complete the transaction. In the event that the lender needs to repossess a work of art, they are required to schedule a liquidating auction, and need to sell off the collateral at an unpredictably dramatic discount, in what is a notoriously fickle market. That being said, because of the way in which a liquidating bank has access to a client list of individuals that purchase such works of art, they are able to capitalize on the situation by using it as an opportunity to drum up business.
Specifically, they are able to take the opportunity to call every single person on their list of wealthy art-buying clients, and pre-approve them for a loan against any art work that may be coming up for sale at the next auction. Similar to the way in which banks will make profits by encouraging car shoppers to make impulse purchases through the issuance of credit cards, they can expect to earn a return on upcoming art auctions in the way in which the buyers will need to finance every single one of the purchases they make, as opposed to just the single one that they are replacing. The end result is a situation where a loss on a single piece of collateral becomes a gain on forty more, as the lender takes on new business from multiple new clients.
By then combining all of these new loans into a portfolio, the risks of lending become much more reasonable. In fact, statistically speaking, a portfolio of loans secured against art-work at 60% collateral value will have a total default rate of approximately 2.6%, which is only 1% more than a mortgage, even though it comes with an interest rate that is twice as high. So long as the bank is then in a position to continue churning through its defaults in a way that keeps business moving, they’ll continue to make a healthy profit on the transaction.