Houses of Cards

Houses of Cards
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Since last November, we have heard leaders of the largest auction houses and galleries (henceforth, traders) comment on how their firms will cope with the most serious collapse of global capital markets in at least 80 years. Like their peers in other sectors, art executives describe their plans in terms of downsizing or shrinking balance sheets. Curiously, they have not mentioned that a tsunami has knocked the stilts out from under their core business tactic of the past decade, one that has played a huge role in expanding markets and raising prices: using cash advances, guarantees and loans to win business.

Some background. From the time Herodotus first reported the existence of auctions — of young women in Babylon — until the mid 1990s, the basic business model for buying and selling on the block changed very little. Sellers brought assets to a public auction or a dealer’s gallery and departed with cash. Buyers brought cash and departed with assets.

So what happened during the 1990s? Following the collapse of a Japanese-led art-buying binge in the late 1980s, major traders were struggling to offset their nearly negative net worths. To compensate for this and for the fact that buyers were staying away in droves, they sought to entice clients by offering the lubrication of what in other economic sectors is called trade finance.

The availability to traders of external finance, which they extend in turn to consignors and buyers, typically depends on strong balance sheets and predictable revenue streams. However, since traders earn their profits mostly as agents rather than principals, their financial statements display neither, unless they own real estate. In other words, their business model denies them dependable access to debt markets on reasonable terms.

Consequently, the sources of trade credit they tapped were skittish and expensive. Merely to break even on providing this service, traders have raised their fees to a point at which the total costs of art transactions for both buyers and sellers amount to, for example, roughly eight times those of commercial real estate deals. What worked when credit flowed freely now kills business and diminishes any potential for economic gains from owning art.

Since global credit froze, beginning the week of September 15, the trade credit that had powered art pricing and market expansion has collapsed. What had become the centerpiece of competition among the largest trading firms vanished. In the absence of new external sources of loan capital for traders, it is their shareholders who alone now shoulder this overhanging liability.

So here is the basic conundrum: Art traders have evolved over the past decade into financial intermediaries, filling an almost total void in an otherwise largely illiquid sector. However, the financial framework of their historic business model lacks even the most basic capability to support the tectonic shift in the economy, much less profit from it.

What’s more, a consequence of traders’ extension of costly credit was the creation of what is called a "pricing umbrella." Under the shelter of trade finance, which injected some marginal liquidity into a relatively illiquid marketplace, an immense price run-up was sparked, especially for the contemporary-art submarkets that entail the most severe financial risks of ownership. After that price ignition, several other factors extended the run-up further.

The strategic implications of the current situation — in which competition is based on financial guarantees, cash advances and loans — are more complicated still. Historically, when firms in any sector compete on the basis of pricing or trade finance, it is a classic symptom of a mature commodity-driven market in decline. It signals clearly that there is no meaningful difference among leading competitors. There is a historical analogy: During the 1950s, the American railroads were the last to understand that the world had passed them by. Like it or not, they had become mere links in the global transportation sector. Art traders’ basic paradigm has similarly been shaken to its foundations.

When capital markets resume functioning, as they ultimately will, reputable, reasonably priced sources of external finance will materialize only if traders take the following steps:

1. Reconstitute their boards of directors. Replace the socially connected members with independent, seasoned operating executives from other sectors to improve governance.

2. Focus resources on key values. The art sector is distinguished by its unique, efficiently gathered scholarship and its successful cultivation of the best-educated, wealthiest men and women in the world: individual large-scale collectors. Tightly restrict overhead to nourish these two central attributes.

3. Create a standardized nomenclature and develop a statistically based system for capturing sectorwide transaction data in real time. Unlike the art market, the capital and commodities markets do provide this information, enabling investors to assess their financial risk and correlate their ownership of such assets with other investment options. Contrary to opposing arguments, such systems don’t create monopolies, disclose proprietary intellectual property or reveal operational secrets. The costs of continued failure to build this capability for the art sector are untold.

The art sector’s need for information and liquidity has outstripped the ability of its major institutions to provide them. Failing to correct this severe imbalance will threaten the existence of some of the largest, oldest firms. Rather than cause despair or denial, this should be a spur for renewal and strategic redirection.

David Kusin founded Kusin & Co., the economic research firm that produced The Modern and Contemporary Art Market in 2005.

"Houses of Cards" originally appeared in the March 2009 issue of Art+Auction. For a complete list of articles from this issue available on ARTINFO, see Art+Auction's March 2009 Table of Contents.