Luft Gesheft

"Luft Gesheft" is a business that looks like a business, sounds like a business, acts like a business, but isn't a business. The Yiddish phrase "Luft Gesheft" literally translates to "business in the air." It refers to a business that is based on "hot air" without a solid foundation.

Luft Gesheften are not really businesses based on fraud or a desire to cheat people out of their money. More often than not the problem with a luft gesheft is that it is based on a premise which doesn't or can't work out over the long-term. Initially things look good and the company makes money. However, over the long- term, problems that could have or should have been foreseen emerge and eventually the walls come tumbling down.

Now contrary to what you might be thinking, this story is not about the Lorenzi affair (see separate story on page 12). No, it is about you and me, about all of us in the diamond industry. Lorenzi is doing us a favor. He is waking us up to the fact that large segments of our diamond industry have become a luft gesheft.

Lots of folks are alarmed about Lorenzi. Not because they care about Lorenzi or his Israeli creditors, but rather they are wondering if the same thing can't happen to them. After all, what is our business really based on? How solid are we financially? Are we all living on borrowed money? Borrowed time?

It is time to face the fact that there is something very wrong with the financial structure of our industry. Over the years we have moved away from a normal cash-based industry where diamonds are bought and sold for immediate (or maximum 35 day) payment. We have become an industry whose sales are based on long-term credit and memo deals.

Often diamond "sales" aren't really sales at all. Dealers and manufacturers give diamonds away on memo to retailers with the hope of making large profits if the diamonds sell. If the diamonds don't sell they are returned to the supplier. This type of selling is really nothing more than gambling. All of the risk is with the diamond supplier. If there are few returns, then profits look good and the game goes on. However, if the supplier gets huge returns he may not have enough money to pay his suppliers. Furthermore, the diamonds that get returned after a weak season are not worth a fraction of the memo price.

Even when diamonds are officially sold, retailers often delay payments. Diamond suppliers are not seen as diamond suppliers anymore, but rather as diamond financiers. The wealth and financial assets of the diamond industry are no longer being used to provide vital liquidity in the trading markets. Instead, diamond dealers and manufacturers have become cash cows to be milked by the retail sector of our industry.

The sad fact is that we have become a schnorrer market, a market of beggars. Everyone owes everyone too much money. Instead of selling diamonds, we compete to give them away. Then we spend our time begging customers to pay us. We have taught our customers that they don't need money to buy diamonds. They can borrow them and/or get them on credit. If customers don't pay us on time, so-what? We don't cut them off and refuse to sell them again. Instead we find new and creative ways to extend financing. Sometimes suppliers just don't pay their suppliers on time. Everyone's credit is based on everyone else's credit. If our customer doesn't pay us we don't pay our supplier.

The cycle of credit in the diamond markets has gotten so bad that it is hard to tell who has any real money anymore. Who is able and willing to stand behind their financial commitments? Everyone is looking to everyone else for money. But who has any real money?

Cash is so tight, that many retail customers don't have money to buy diamonds. They are too used to getting them for free. Even if dealers offer retailers a great discount for cash payment they don't take it, because they simply do not have the financial capacity to pay cash for diamonds anymore. Diamonds have gone from being a cash commodity to a credit commodity. Diamond suppliers who once defended their goods and held out for cash sales are now falling over each other to sell their diamonds on credit.

The diamond business has become a luft gesheft because payment is no longer based on cash. Instead, payment is based on the ability of your customer's, customer's customer to pay his bills. If, G-d forbid, we have one very bad holiday season, then poof, the entire house of cards will probably come tumbling down.

It is probably a good idea to see how we got into this mess, so we can figure out how to get out of it. Some of the old timers believe that it all started when the U.S. government canceled import duties on loose diamonds in the Seventies. Until then, U.S. wholesalers had a relatively stable U.S. customer base with limited competition from foreign suppliers. Once the import duties came off, foreign diamond manufacturers and dealers came into the U.S. market selling their customer's customers. U.S. wholesalers had to find a way to keep their customers in the face of severe price competition from the foreign suppliers now penetrating the U.S. market.

Some very large, bright and aggressive wholesalers figured out how to compete against the foreign suppliers. They would package their diamond sales into programs that addressed a broad range of their customer's needs. The programs provided liberal credit terms, memo arrangements, price guarantees and everything else necessary to ensure that their customers did not leave them for other firms that were offering better prices. The programs were structured so that their customers would not be able to buy diamonds from any other significant suppliers without losing the package benefits. In effect the programs tied-up the customers buying commitment for the year locking out the foreign suppliers. 

Since the U.S. wholesalers could not compete on price, they had to hide the price as part of a bundle of services. For many retailers, price became a secondary consideration when buying diamonds. Far more important were the overall terms of the deal and the comprehensive package offered by the supplier.

The net effect of program marketing was that diamond sales became much more difficult for ordinary suppliers. If you couldn't provide liberal credit and a package of services, you couldn't sell the majors (large retailers). And if you couldn't sell the majors you had to run a smaller, different type of business.

What started out as a defensive maneuver by large U.S. wholesalers developed into a new type of competition in the diamond industry. Price competition became less important than service/program/credit competition. For the first time ever having the right goods at the right prices did not guarantee success.

The system worked for quite a few years until the foreign firms were able to learn the U.S. market and come up with their own sales programs. As the markets developed the programs became more sophisticated and suppliers began to compete on a whole range of services. Large foreign firms could buy into the huge U.S. market by offering very attractive programs.

Often these programs were not economical, but were justified by the desire of the foreign firm to become a major player in the U.S. market. After a while it became almost comical. Every year the majors would sit back and wait for the latest sucker to enter the game. The foreign firm would proudly capture their major by offering a program that was too good to be true. Sure enough, as the level of returned product mounted after the holiday season the foreign supplier would suffer severe indigestion and set the stage for the next supplier to buy his way into the market.

While program marketing in the U.S. played a major role shifting the marketing emphasis from price competition to credit competition other forces are also at work. In normal markets prices reflect market realities. In other words, prices go up or down depending on the level of supply and demand. In general, prices are the primary force regulating market activity and provide a way for markets to optimally adjust the level of supply and manufacturing activity to shifts in demand.

Given the sharp fall in diamond demand due to the collapse of the Far East markets, one would expect diamond prices to decline sharply. While lower prices are often seen by the trade as something bad, in effect good because they allows the markets to adjust to new realities with a minimal level of inefficiency. It is sort of like going to the dentist, painful in the short-term but very necessary for the long-term.

The diamond industry is unique due the monopolistic role of the De Beers Central Selling Organization (CSO). The CSO does its best to control diamond prices and not allow them to settle down to "normal" market levels. The CSO keeps rough diamond prices high even though polished demand is significantly weaker. The net effect is that even though polished diamond prices are under downward pressure due to declining demand the cost of producing new polished diamonds is high due to De Beers rough prices.

Obviously, diamond manufacturers lose money in this scenario. In order to limit their losses, they do their best to get the highest possible prices. For many manufacturers this means selling farther and farther down the pipeline (i.e. selling their customer's customers). In other words instead of selling diamonds for cash terms to dealers, manufacturers are now selling for longer credit terms to retailers. Instead of being liquid, diamond manufacturers are now directly caught up in the credit game.

The problem with getting higher prices for credit sales is that often these higher prices are not really higher. Sure when one compares the prices, the price per carat for credit sales is higher, but what about the true costs of these credit sales? More often than not the credit seller does not properly evaluate the cost of credit after payment delays, cost of collecting the money from the retailer, and the risk involved in the credit sale. The numbers look higher but they really aren't. The credit seller is often suffering from price illusion. In other words, the price he is getting may look higher, but it isn't really higher than the cash price.

Cash markets tend to be highly efficient as the people that have cash in their pockets tend to be the most knowledgeable traders. Perhaps the most disturbing aspect of the diamond markets these days is the huge differential between cash and credit prices. In some instances, the difference can be as high as 10 to 15 percent for 90 days credit. This significant price differential is testimony to the unhealthy status of the diamond industry today. On the one hand, the large price differential points out the severe liquidity crunch our industry is in. On the other hand, it points out the high level of risk absorbed by firms that provide liberal credit.

It is understandable that diamond manufacturers do not have the stomach for polished cash price levels given the high cost of rough. But are they better off by fooling themselves into thinking that they are doing significantly better by destroying their liquidity? Ultimately, everyone has to get caught up in cash flow problems if the only way they can do business is by selling on medium-term credit.

The bottom line lesson here is that cash prices are real, while credit prices are an illusion. If you can't sell for cash what makes you think your goods are worth credit price levels over the medium-term. Eventually, you will have to base your business on cash prices if you are to stay liquid. In essence, if you can't manufacture diamonds and sell them for cash at a profit, you shouldn't be manufacturing. If the only way that you can make money in the diamond business is by providing credit, perhaps you should be in the banking/finance business instead of the diamond business.

The credit games in the diamond industry have probably not yet run their course. Undoubtedly, firms will continue to provide liberal credit to their customers until they get burned. Right now it is hard to predict who will lose money, how they will lose money, or when they will lose money. We can, however, point out that for the diamond industry overall, the trend towards increased credit sales will have to come to an end. There is simply no way this game can continue without the collapse of the entire system. Ultimately, we are simply going to run out of money.

While the diamond banking system has been enjoying the ride so far, it appears increasingly likely that banks are going to become more conservative in the near future. Certainly, the banks in Israel, under instructions from Israel's central bank, are going to have to tighten up lending policies following the Lorenzi affair. Furthermore, while U.S. demand is holding up rather well, bankers are concerned about the decline in equity values, and the level of finance is likely to come down after the holiday season.

Ultimately, the diamond industry is going to have to find its way back to its roots. Namely, the establishment of efficient cash markets for diamonds that provide manufacturers and dealers with a reasonable level of liquidity. Unless De Beers decides to start selling rough diamonds on credit, it seems likely that rough and polished diamonds will have to reflect more realistic, lower cash price levels in the months ahead. The current level of prices based on liberal credit policies does not appear sustainable. While rough and polished diamond prices in the cash markets will probably be significantly lower than current credit price levels, they will provide the trade with a firm basis upon which to reestablish the financial strength of our industry.

How and when the cash markets reestablish themselves will be of great importance to the trade. Hopefully, it will not result from a major collapse of the credit system involving large losses for credit holders. We would hope to see a more gradual development whereby a new breed of diamond dealers and retailers develop cash markets for diamonds based on price competition.

The trend towards the commoditization of diamonds through increased certification of better quality stones and intense competition among mass merchandisers selling price-point jewelry will re-focus retailers on pricing. Over the medium-term, we would expect retailers that have been relying on memo diamonds at "high prices" to suffer decreasing profit margins as retailers that take a bit more risk and pay "low cash prices" for diamonds enjoy increasing profit margins. At some stage in the near future retailers are going to wake up to the fact that the only way to significantly increase their profit margins and competitive positioning is to buy diamonds at lower cash prices.

While the establishment of cash markets might not be welcome to firms that do not want to see a decline in "illusionary" diamond prices it does not appear that our industry has any choice in the matter. It is high time for our industry to get its feet back on the ground. This luft gesheft business must end.