RAPAPORT... Once upon a time, the diamond trade was all about cash. Accounts were settled every Friday. Buyers would show up at the club with a briefcase, plunk down stacks of money and walk out with diamonds. Business was straight. Diamonds were worth money.

Over time, our industry evolved and we became more sophisticated. Restrictive distribution schemes squeezed rough prices higher and made downstream marketing initiatives compulsory. Profit margins evaporated. Diamond manufacturers and dealers began selling programs instead of diamonds. Programs offered retailers long-term credit, memo inventory and return privileges. Diamond dealers became salesmen more interested in selling the sizzle than the steak. They gave diamonds away to retailers with “Don’t pay until you want to” programs.

Initially it made sense, in an evil sort of way. Retailers gave suppliers a share of their profits in return for not having to own and finance inventory. Suppliers charged more for diamonds and paid higher rough prices. Program sales became a way for the trade to suck up downstream retailer profits and deliver them to the rough producers.

Like a giant Ponzi scheme, it all worked well as long as the economy grew and diamond prices increased. Once the recession hit, the “good” retailers returned diamonds while the “subprime” retailers went bankrupt. Polished suppliers realized that they had taken a huge inventory risk without retaining sufficient profit margin. As demand, prices and liquidity plummeted, the polished sector was left holding the bag.

We must face the fact that credit/memo programs have hurt the U.S. market. In our eagerness to throw diamonds at every potential customer, whether they had money or not, we prostituted our product. We used every trick and gimmick to keep diamond prices artificially high, and in that process, fooled ourselves into thinking we could sell diamonds without getting paid. Where once we sold diamonds for hard cash, we now can’t get paid — even if we give diamonds away on memo programs. The U.S. market has gone from a cash cow to a credit hog.

The situation has gotten so bad that sellers can no longer even imagine selling for cash. When I tell polished suppliers that they must move to cash sales, they think I’m crazy. “It’s impossible,” they say, “our buyers don’t have money.” And so we come to the crux of the issue. Why is the diamond trade selling diamonds to people who don’t have the money to pay for them? When will this house of cards collapse?

Credit is a good thing as long as you don’t need it. Someone who uses his credit card to facilitate transactions and pays his monthly bill on time is using credit properly. Someone who finances his lifestyle maxing out credit-card debt and paying 25 percent interest is on the way to bankruptcy. How is the jewelry industry using credit? Do our customers have money or are they living off credit?

Short-term, 10- or 30-day credit is one thing; 90-, 180-day and longer credit is something else. Face it, when your customer sells your diamond and does not pay you — do you know where your money is going? Are you financing someone’s payroll? Is Peter buying from Paul to pay Mary? Why are you extending financing above and in addition to what a bank provides? Are you smarter than the customer’s bank? Are you in the financing business or the diamond business?

We should consider that interest rates are currently at historic unsustainable low levels. What will happen when interest rates increase rapidly and significantly? Will you be able to afford all those long-term credit deals? Will you be forced to dump inventory in the face of high interest payments? How about your friends? Will they be dumping diamonds too? Will your customers be paying you on time? Are you currently reducing your credit risk or are you an accident waiting to happen?

The diamond industry is facing unprecedented financial risk as it continues to overextend credit to buyers while failing to prepare for the advent of significantly higher interest rates.

But that’s not all. Perhaps the greatest problem caused by credit overextension is the misallocation of resources. Diamonds sold on long-term credit/memo get stuck in the pipeline. Jewelers are not incentivized to sell them because they have no “sweat equity” — i.e., money — in the diamonds. They also don’t make a decent profit margin because suppliers are charging a large financing, risk and memo premium. So, why should jewelers push diamond sales if they don’t have their money tied up in the stones and they make low profit margins? Is it any wonder that the average U.S. jeweler only turns diamond inventory once a year?

By now, it should be clear that long-term credit/memo programs are dangerous. They not only present unacceptable levels of financial risk but they take the commitment and profit out of selling diamonds. Should such large-scale programs persist, the diamond industry may yet choke on its own misplaced inventory. We must take responsibility for where we put our diamonds.

All of this leads us to an important question. Why should jewelers pay for diamonds if they can get them on long-term credit? While some jewelers may continue to work on credit/memo and suffer accordingly, a new wave of educated buyers is seeing the opportunity in diamonds and learning how to use cash purchasing power effectively. In some instances, the price difference between cash and memo can be 20 percent to 30 percent. Smart buyers are going to play off these discounts and compete against the poorly financed jewelers with bloated prices. Ultimately, competitive market forces will do their work, eliminating inefficient overpriced jewelers as cash buyers optimize allocations of polished diamonds.

Another unfortunate aspect of the credit situation has been a trend for firms to use the economic crisis as an excuse for not meeting their financial obligations. Shockingly, some firms have been trying to negotiate large discounts on their debt with the intention of continuing in the diamond business. Easy credit has given way to lower ethical standards. In my view, this is entirely unacceptable and is a threat to the integrity of our trade. “If you can’t pay, you can’t play” must be an enforceable standard. It is high time that, subject to legal advice and constraints, we name, blame and shame those who do not meet their financial obligations.

Belgian banks recently announced they “may provide up to” 1 billion euro ($1.4 billion) of diamond financing. It’s nice to see that some of the banks that were bailed out themselves are now willing to bail out some of their customers by attaching old inventory at a 30 percent rate. While it’s hard to imagine the new money going anywhere but back to the banks, we do note the irrational increases in rough prices with concern and are hopeful that excess bank liquidity will not be used to increase rough speculation or boost polished prices. One hopes that the banks and the Belgium government recognize that, at this stage, the diamond industry and its banks do not need more liquidity. What they do need is to handle their money and credit more responsibly.

In conclusion, the diamond industry must tighten its credit policies and support more realistic cash price levels. Liquidity must be established based on real values in the cash market. Long-term credit and memo programs are highly problematic, as they support inflated prices that reduce retail profit margins and sales volume. Over time, we expect cash market buyers to increase price competition in the retail sector, reducing the dominance of program sellers. Firms that do not meet their financial obligations should be encouraged to exit the trade.

While the outlook for diamonds remains mixed, those who aggressively adopt new business models and work the cash markets will enjoy significant competitive advantages. The industry appears unprepared for the likely advent of significantly higher interest rates that will pose a serious threat to the existing credit structures and price levels. Now, more than ever, strategic optimization is a prerequisite for survival. Firms that reassess their strategic positioning in light of the significant changes in market conditions will enjoy significant competitive advantage in the years ahead.