(Roughly) How The Great Art Bubble Worked

I bought a DVD of Ben Lewes' 2009 documentary on the Great Art Bubble while visiting the Tate Modern last Tuesday. I watched it a couple of times and let the whole thing simmer in my unconscious for a while. Lewis never did work out what was going on, or if he did, his lawyers told him not to explain it. But the following Sunday I got it. It's almost as complicated as explaining a credit default swap, but that's why everyone got away with it for so long. It's not something you'd think up for yourself unless you worked in the markets (I don't, but I didn't think it up, I just figured it out afterwards).

Here are the ingredients: 1) a low cost of borrowing, 2) a bank or banks willing to lend a reasonable amount of the value of an artwork to its owner, 3) a thriving but very secretive private sales operation, 4) a thriving and very public auction market, 5) an acceptance by all concerned that the auction market sets the price of an artwork (however temporarily), 6) a small enough number of insiders who “all know each other”, 7) a sufficient supply of outsiders, marks and newcomers, 8) a supply of recognisable but essentially commodity-like artworks.

Now suppose you own four of Andy Warhol's Jackie screen prints. You bought them for, say $50,000 each. You put one up for auction with Sotheby's and ask me to bid for it: I can go as high as $500,000. You will be bidding by phone, to create the appearance of genuine activity and to make sure the price gets up to target. The auction comes, I bid and “buy” your Jackie for $500,000. You pay Sotheby's the seller's premium and cover me for the buyer's premium. Since you're an insider, you get a discount on both. You hand me $500,000 of your money so I can pay Sotheby's so they can pay you $500,000 of your money. Net zero. You have now established (item 5) a new record price for a Warhol Jackie. Not bad huh? Especially since you get your Jackie back in a “private sale” which is as fake as the auction sale but keeps the paperwork straight. (Because I paid with your money – remember?)

Here are some ways you can benefit from this little maneouvre. You can borrow some money from the bank (item 2) against the new value of your four Jackies. Since the other three of your Jackies look just like the fourth (item 8 and the important one), it's easy for the bank to lend me you, say, 50% on the new value of your Jackies (item 2). So you have $1m, on which you are paying perhaps 4% (item 1).

Or you could sell one of your Jackies privately (item 3). Believing the auction price (item 5), the buyer is expecting to pay $500,000, but most likely will be thrilled to get it, after a little fake negotiation, for, say $200,000. You have certainly sold it for more than you could have done before the auction. Anyway, the buyer doesn't care, because they aren't using their money, they can borrow it from the bank (item 2).

Even if I had to pay Sotheby's the full auction price, I can negotiate delayed payment terms. Like maybe a year. Which gives me plenty of time to sell a couple of my Jackies at the new, improved price. I'll get the money back and make much more profit than I would have done selling at the pre-auction price. Is it risky? Yes. But then that's part of the rush for these guys.

And there's even a chance that some third party follows our bids up, and at a pre-arranged price (say $400,000) we both drop out and let them have the painting. Which will be real money from a real sale. Double win.

It's a rich man's game – you have to pay auctioneer's premiums, interest, insurance, packing and storage and none of those things are cheap in absolute terms. But it can beat the heck, on a risk-reward basis, out of leaving your cash on the overnight markets. And you get to hang out with some cool people, read about yourself in the papers and maybe score with some of those pretty girl who hang around the art world.

The commodity nature of the art – Hirst's Spin and Dot paintings and those endless Murakami's to name but three – is essential to the game. Bankers don't know much about art, they have no idea why one Victorian painting of a country lane is worth ten times more than another one. If they wanted valuations, they would have to hire an art consultant or ask the auction houses. But one Spin Painting looks like another. (And one Monet Haystack looks just like another as well. Red Jackie, Green Jackie, Yellow Haystack, Blue Haystack. These guys weren't the first to produce commodity art.) So if one Spin painting goes for $6m, so should the next. It's also why the publicity is so important: the bankers need to recognise the names. The books, the exhibitions, the jargon-filled articles in the Art magazines – all these go to creating and improving the artist's brand.

Seems too fantastical to be true? Do you really believe that these dealers actually hand over those sums of money when they buy their own artists? Do you really believe that Roman Abramovich, a man smart enough to get $12bn out of Putin's Russia, really handed over $80m of his own actual cash for a Francis Bacon painting? When he knows the only people with more money who buy paintings are the Arabs, so he has no market to sell on to? Anyway, if he wants to throw away money, he has Chelsea.

No. If something sounds crazy, it usually is. What I've described – and the endless variations a skilled trader can play – is about how it has to be. All that art was bought with money borrowed at low rates against a hefty fraction of its auction value. The real sales happen at much lower prices in private deals, and while the majority of auction dealings in regular artists are as kosher as auctions ever are, the dealings in the big-name brands are best assumed to be, well, fake. And if you're looking for at least one of the banks prepared to lend, why do you think UBS sponsored all those art fairs? Oh, and yes, all the auction houses know what's going on and yes they are that, well, client-focussed, though others may prefer the harsher word 'unscrupulous'. Read the books about them.