2008 Forecast: Subprime Woes Hit the Art Market

So, you thought that the subprime crisis was restricted to the real estate market? This past year, the leading auction houses greatly ramped up the rate at which they extended guarantees to consignors, assuring those consignors that if the consigned artwork did not sell at a minimum target price, the auction house would purchase the artwork from the consignor. By some estimates the total amount guaranteed this year was three times the amount guaranteed only one year ago. This is a very disturbing trend.

If you assume that the auction house estimate of the price range at which the artwork would sell is a reasonable indicator of the house’s view of the value of the artwork, then you conclude that its guarantee is a commitment to buy the artwork at less than its own estimate of fair market value. Hardly a very smart deal!

At the core of the subprime conundrum is a loan extended to a borrower who does not have sufficient credit or assets to justify the loan. If a credit deficient borrower borrows 110% of the value of his new home from the lender, the loan is subprime. Well, if the auction houses buy art from their consignors at prices above their own estimate of fair market value (say, 110% of the value of the artwork), that’s a subprime art transaction. The auction house is left holding an asset worth less than what it paid for it. In addition, the auction houses are not likely to hold art acquired in this manner for long durations; financial good sense mandates that these works will be sold quickly to minimize losses and close out the transaction.

To further aggravate the situation, the increased supply of artworks for sale will push prices further downward and increase the number of artworks that the auction houses will be forced to buy to honor their guarantees. Does this sound like an hysterical downward scenario? Well, it’s about as crazy as thinking that Merrill Lynch could lose $10,000,000,000 in one quarter attributable to its subprime loan portfolio.

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