Worst Abuses Of Unregulated Art Market Look A Lot Like Typical Day In Financial Industry

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If you like or hate financial regulation you might take a quick look at today's front-page New York Times article about how the art market is unregulated. Apparently this leads to terrible things like "chandelier bidding," where auctioneers get the ball rolling by calling out a few fake bids, as well as conflicts of interest involved in third-party guarantees where someone writes the auction house a put on an artwork, is paid a variable commission for that put, and in some cases is allowed to credit that commission against his own bid for the artwork.1 One question you might ask is "why is that bad?"; the answer seems to be that some rich people who go to art auctions pay more for art than they would in the absence of these systems, and then feel vaguely uneasy about it. I think the whole thing disappears in the face of one more iteration of "well, why is that bad?," but perhaps I am wrong.

There are places where you should think "customers should be protected from various sorts of sharp practices by dealers," and there are places where you should not think that. I guess? Are there only the former?2 I come from a place that believes deeply in the separation between "sharp practices" and "illegal fraud" and works to keep them distinct. One thing the Times article mentions is that there is a law saying that stores have to display the price of their wares, and art dealers ignore that law, and this is bad for some reason. Try that law on derivatives dealers. One of the main driving forces behind financial innovation is finding novel places to hide fees.

The rest of the art-auctioneer tricks also seem pretty familiar. Imagine an M&A banker who couldn't bluff, to the one serious bidder for an asset, that he had other bidders waiting in the wings. And of course the financial industry is very familiar with the creative use of options and guarantees to allocate value in ways beyond a headline purchase price. One flavor of that is "schmuck insurance."3

Basically every horrible thing allowed by the absence of regulation in the wild-west art market is pretty much standard practice in the highly regulated financial markets.4 Which ... which will probably precisely confirm your priors, whether they are "regulation is dumb" or "the financial industry is full of scumbags." As Matthew Klein at The Economist's Free Exchange blog put it, in discussing calls for financial-crisis prosecutions and the Morgan Stanley shitbag CDOs: "One explanation for the confusion is that many things that are considered normal in finance look like fraud to almost everyone else." Even, apparently, art investors.

And now perhaps someone - some NY state legislators, as it happens - will finally get around to protecting those investors from their hobby, and hey that's super.

In the financial world things are more complex. Consider this weirdly ominous FT article about bank "living wills":

US regulators have warned banks not to assume [in writing their resolution plans] that countries will work together to avoid the catastrophic failure of a financial group. ... Several bank executives told the Financial Times that the guidance – which one called “shocking” – left them believing regulators were losing confidence in their ability to improve on 2008 when countries either failed to co-operate, or even fought over assets, in banks from Lehman to Landsbanki in Iceland.

The "living wills" are sort of a silly thing, full of vague theories about how to wrap up a multitrillion-dollar global balance sheet in the face of an unknown but bad future crisis. If you could actually plan for it it wouldn't happen, etc., so you're left with vagueness. One part of your vague plan could be "we expect that national regulators won't stop us from doing sensible things like selling off assets etc."; alternatively, your vague plan could be "here are all the things that we'd do assuming that national regulators are as unhelpful as possible." Sort of by definition the second plan will be worse than the first, systemic-risk-wise, but what can you do.

The failure to cooperate is not, of course, driven by stupidity or malice: it's driven by each regulator's desire to protect the customers and investors in its jurisdiction. It's just that those are, y'know, different customers for each regulator. You don't have to go back to 2008, or even to cross-border cases, for examples. Just last year, MF Global dissolved amid turf battles between the SEC (which oversaw MF's broker-dealer and protected securities customers) and the CFTC (which oversaw its futures commission merchant and protected futures customers). The regulators fought over what MF Global could do with $220mm of money that was in a broker-dealer account: each regulator wanted it for its own customers and so they "worked at cross-purposes," telling MF Global contradictory things about what it could do with the money. In MF Global's confused final days, it's hard to imagine that this helped. The WaMu story is full of similar disputes between the FDIC, charged with protecting depositors and its own insurance fund, and Fed/OCC/Treasury, charged with protecting the financial system as a whole.

The FT article goes on to note a "tone of optimism" at the Basel regulatory coordination meeting, quoting what I assume is a banker saying approvingly that "regulators are listening now and moderating their approach." Regulators who "moderate their approach" to protecting people who fall into their jurisdiction really might be doing the right thing for the overall health of the financial system. But judging by some people's out-of-nowhere desire to regulate the art market, you can guess that they'll get some pushback.

As Art Values Rise, So Do Concerns About Market’s Oversight [NYT]
Just who should we be blaming anyway? [Free Exchange]
US regulators warn banks on living wills [FT]

1.That is what this sounds like:

A guarantee typically operates as it sounds. When someone offers a piece for auction, the house will sometimes guarantee that the seller will make at least a minimum amount by arranging with a third party to purchase the work for a specific price, undisclosed to the public, should it fail to sell for more. In exchange for putting up the funds, the guarantor, whose name is also not revealed, gets a cut of any proceeds above the guarantee. ... The problem, some dealers, collectors and art advisers say, is that the neutrality of an auction is lost when these underwriters can bid on a work they’ve guaranteed. Critics argue that the guarantors have an undisclosed interest in the outcome and an unseen advantage over other bidders because a buyer who wants the work might wind up competing against someone who only wants to bid up the price. ... At Christie’s and Phillips, both large auction houses, even if a guarantor ends up owning the work, he would still pay less for it than anyone else. For example, if a guarantor’s bid of $12 million turned out to be the winning bid, the guarantor would not pay the full $12 million because he or she still gets the cut — called a financing fee — of any amount above the $10 million guarantee.

If you don't like the put terminology consider that the guarantor has basically bought the thing at the guarantee price and is then selling it to the public, given the auction house and prior owner a cut.

2.Are there only the latter? A million libertarians shout "YES!" I dunno. I'm willing to believe that most people should be protected from most home-mortgage sharp dealing. Rich people's purely extracurricular activities seem distinguishable though.

3.In fact, on Friday's CNBC slugfest Ackman specifically said that he accepted a lower headline price for the asset he sold to Icahn in 2004 - someone else offered more cash - because Icahn was offering him schmuck insurance and he placed a value on that optionality.

4.Well, in some of them. This is all less true in on-exchange trading: Fake orders there are frowned upon, as are side-letter deals that pump up reported purchase prices while transferring some value back to the buyer. (Though ponder this situation.) It's very context dependent.

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Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels: