There goes the bling.

For auction house Phillips de Pury & Co., it was to be the kind of buzzy, art world event that would make money and the tabloids: "Hip Hop's Crown Jewels." The October sale of rapper finery was to include Lil' Jon's signature 12-pound diamond "Crunk Ain't Dead" pendant, appraised at $500,000, and pieces worn by Notorious B.I.G. and Tupac Shakur. But with the financial system melting down, the New York-based Phillips first bumped the auction to early March, then bumped it again—off the calendar indefinitely.

As the art market falls to earth, Phillips de Pury is a telling window onto the wreckage. The smallest of the three main auction houses—its sales are about a twentieth of either Christie's or Sotheby's—Phillips set itself apart during the boom years as a fast-moving salesroom for pieces by trendy contemporary artists like Ugo Rondinone and Anselm Reyle. It offered buyers a way to bypass gallery wait and wooed sellers by promising large minimum returns, known as guarantees. Simon de Pury, the house's Swiss-born chairman and auctioneer, also injected a dose of flash into the staid auction arena, and evenings at the house's Chelsea headquarters were packed with collectors in their thirties and forties sipping champagne and gossiping in a dozen languages.

But in down times, as speculators drop out of the market, it's the hottest art that cools the fastest. Previous top-earners Damien Hirst and Jeff Koons are experiencing slumps, and seasoned collectors have begun investing their money in proven post-war, Modern, and Impressionist works—as witnessed at Christie's $264 million sale in February of works belonging to designer Yves Saint Laurent and his partner, Pierre Berge. In this climate, Phillips' strategy of focusing almost exclusively on new artists is now looking like the company's Achilles heel.

A year ago, when customers began delaying their payments to the auction house, de Pury discontinued his practice of offering guarantees. That move, in turn, reduced both the number of consigners and the quality of lots Phillips attracts. Last fall's sales were disastrous, and close to half of the house's lots didn't sell. To boost those sales percentages at the major contemporary art evening auction in February, the house offered just 53 works, compared with 211 the year before. Of those 53 works, 18 failed to sell, despite an energetically cajoling performance by de Pury. The $6 million in receipts far undershot last year's $42.8 million take for the same sale. Most recently, March's Under the Influence sale—an auction offering work by emerging artists at reasonable prices—eked out only a modest return of $1.6 million in New York.

Christie's and Sotheby's are of course suffering as well, with their contemporary sales vastly deflated. In their combined February evening contemporary-art sales in London, the two houses took in just over $38 million, compared with $331 million the year before. Between February 2008 and 2009, Sotheby's stock plummeted 88 percent, and it has announced a plan to cut costs by $100 million this year. Both houses have laid off staff. The difference is that Phillips, with only modest auctions of photography, jewelry, and design, has no fallback position. "Either Christie's or Sotheby's can shift its emphasis from painting to jewelry or from painting to furniture in any one of their markets—Phillips doesn't have that kind of flexibility," said art adviser Allan Schwartzman. "They're going to have to be very clever to adapt to this market if they're going to survive. For the longest time there really wasn't a place for a third auction house in this market."

An atmosphere of "gallows humor," as one longtime buyer put it, has descended at Phillips. The already spare company has cut back its staff, and further cuts are expected under new CEO Bernd Runge, a former VP of Condé Nast International, who took up his post March 1. Even the lifeline extended to Phillips in October—the sale of a controlling interest to the Mercury Group last fall for a reported $60 million—acquired a pallor as conflicting rumors began circulating. Some in the art world speculated that the deal with Mercury, Russia's largest luxury conglomerate, wasn't an investment at all but rather a fire sale. Others wondered if Mercury would come through with the cash. "Nobody knew if it was for real," says Richard Feigan, a veteran New York art dealer. "There's no transparency." Now, only six months into the deal, Mercury's owners Leonid Friedland and Leonid Strunin are said to be suffering buyer's remorse as the Russian economy continues to deteriorate. The two men declined to comment and directed questions to Simon de Pury, chairman of the auction house. De Pury acknowledges that the firm is cutting costs and trying to create "maximum efficiencies," but says that Friedland and Strunin "are in no way discouraged by the general climate and are stimulated by the opportunities this offers."