South Sea Bubble

SOUTH SEA BUBBLE

 
 
[The following text closely follows Garber (1990, 2000) and Neal (1990) but contains information from other sources as well.]

"The Governor and Company of Merchants of Great Britain Trading to the South Seas, and other parts of America, and for Encouraging the Fishery", better known as South Sea Company, was proposed in 1710 by George Caswall, London merchant, financier, and stock broker, and John Blunt, London scrivener turned stock broker. They proposed to the government of Robert Harley that the 9.47 million pounds of outstanding short-term war debts, not funded by a specific tax, be converted into equity in a new joint-stock company. Similar debt-equity conversions were used previously and successfully by the Bank of England and the New East India Company. This South Sea Company (SSC) would enjoy future profits anticipated from a monopoly on English trade with the Spanish colonies of South America (South Seas), and the cash flow on a perpetual annuity from the government paying 6 percent annually. The debt conversion was a success; holders of the short-term debt subscribed 97 percent of the debt into South Sea Company stock by the end of 1711. Actual commercial trade depended on a peace agreement with Spain, and did not develop until after the Treaty of Utrecht of 1713. England gained from Spain monopoly privileges to supply a fixed number of negro slaves to the Spanish West Indies and the right to sail one ship annually for general commerce. In reality, trade did not develop very well, continuously obstructed by Spanish officials and short skirmishes between Britain and Spain. In 1718 South Sea ships and assets were confiscated by Spain. Nevertheless, despite suggestions in the literature, the evidence shows that despite these difficulties and two major interruptions, the slaving activities of the South Sea Company did exist and continued until the late 1730s. As much as 50 ships reached Spanish America carrying SSC slaves (Paul, 2004) [See notes below].

In 1719 another part of government debt was converted into South Sea shares (the 1710 Lottery). In January 1720 the South Sea Company launched the ambitious plan to convert more than half of British government debt. British government debt in 1720 was approx. 50 million pounds: 18.3 million held by 3 large corporations (3.4 Bank of England, 3.2 East India Company, 11.7 South Sea Company). Privately held redeemable debt amounted to 16.5 mln. An additional 15 mln consisted of irredeemable annuities, long fixed-term annuities of 72-87 years and short annuities of 22 years remaining maturity. At the time, British long-term debt was issued in odd sums and difficult to trade, because debt was not divisible and some issues could only be paid if the original debtor (!!) was proven to be still alive. Furthermore, the government was running into difficulties with servicing its debt. A debt conversion program would allow a conversion of high interest, but difficult to trade debt, into low interest, readily marketable debt/shares of the South Sea Company. All parties could gain.

On 7 April 1720, after initial approval on 2 February 1720 and after lengthy discussions between supporters and opponents in both the House of Commons and House of Lords, a bill was passed permitting the South Sea Company to refund the government debt by acquiring the 31 million pound privately held debt. The company had won the competitive bidding against the Bank of England. Under competitive pressure the South Sea Company had raised its offer of a lump-sum payment to the government from 3 million to over 7.5 million pounds (plus apparently approx 1.3 mln in bribes to various persons). To finance the debt acquisition, the company was permitted to expand its share capital. Despite some objections, and perhaps mistakenly, the company was left free to set the price of the shares issued in the conversion.

South Sea share prices started at about 120 pounds per 100 pound par value in January 1720. South Sea share prices reached 950 pounds in July (but this being a less reliable or less comparable price on forward contracts, because transfer books of the company were closed and thus spot prices not available) and finally collapsed from about 775 on August 31 to about 290 on October 1.

 

Fundamentals

Crucial to the 1720 debt-equity conversion scheme was the proportion of holders of irredeemable annuities that could be tempted to convert their securities at a high price for the new shares. (Holders of redeemable debt had effectively no other choice but to subscribe.) The South Sea Company could set the conversion price. The higher the price without discouraging conversion of irredeemables, the more of the new capital issue would be left for the company. For example, at a price of 135 (100 face value), 20mln of government debt could be converted by issuing only 14,814,815 (face value) of new stock, leaving 5,185,185 (face value) for additional fund raising by the company.

For each 100 pounds per year of long and short annuities acquired, the company could expand par value of shares by 2000 pounds and by 1400 pounds respectively. For each 100 pound par value of redeemables acquired, the company could increase shares by 100 pounds. Interest paid by the government on debt acquired and turned into a loan from the company was 5% per year until 1727 and 4% per year thereafter.

The company acquired 85% of the redeemables and 80% of the irredeemables.

The following calculations can be made with respect to the valuation of shares of the South Sea Company in August 1720 (Garber, 1990). Revenue from government annuities consisting of 1.9 million per year until 1727 and 1.5 million thereafter. This represents at 4% discount rate a value of 40 million pounds. In general, assets and liabilities were as follows

net present value of government annuities at 4% discount rate
plus loans to stockholders
plus installments due from cash subscribers
less payment of conversion privilege
less debt in bonds, bills

total value

40 mln
11 mln
70 mln
7 mln
6 mln

107 mln

In September 1720 South Sea Company shares were actually valued at 164 mln pounds (shares 212,012 * price 775). We find therefore that share value exceeded net tangible assets by approx. 60 mln pounds.

Another stock price fundamental calculation takes the announcement in August of a 30% dividend for the current year and 50% dividend for future years. This dividend of at least 30 pounds (30% of par value 100) would suggest a share price of 30 / 0.04 = 750. Historical research shows that financial investors at the time were fully aware of present value calculations for stock and bond prices (see for example, Harrison, 2001).

One might decide to call the above valuation gap of 60 mln pounds the bubble component of the South Sea share price. However, that would ignore the role of intangible assets. The company had accumulated a fund of credit (70 mln cash), available for commercial expansion, and apparently with substantial support of Parliament and the King. At a discount rate of 4%, expected annual profits of 5.2 mln on the investment of 70 mln (or 7.4% ROE) would close the gap in fundamental value (5.2/0.04 = 130 mln)! Many have argued that investors at the time should have known that commercial expansion was not an option. But, in fact, expectations of a resumption of the profitable slave trade and access to Spain's colonies with the help of the government should not be discounted that easily.

Of course, these calculations cannot establish the true fundamental value; such a concept does not exist in reality. Financial market prices on the upside are determined by the so-called marginal optimistic investors, ready to buy at high prices. These calculations can only show that their expectations were not without consideration of fundamental value. Without doubt, some or even many investors disagreed and decided not to participate in South Sea shares. They were proven right, but with proof of this available only after the share price collapse. (Note: Richard Dale's (2004) claim that South Sea investors should simply have known better because there were some critical writings on fundamental value available at the time misses the point entirely.)

Note: In a number of recent papers Gary Shea has analyzed the prices of South Sea subscription shares as values of warrants and options. His conclusion is that the prices of subscription shares are entirely consistent with a rational value of warrants/options. It appears that the usual claims of irrational investor behavior during the "bubble" did not make people loose sight of fundamental arbitrage relationships between traded instruments. The same can be said about international arbitrage, between prices of the same stocks in Amsterdam and London (Schubert, 1988; Neal, 1985.) (Note: At must be said that Richard Dale disagrees with Shea's reading of contemporary legal documents and claims that the interpretation of subscription shares as warrants is incorrect.)

 

Financial panic and price collapse

In August the first of the installment payments of the first and second money subscriptions on new issues of South Sea stock were due. This created a liquidity squeeze and generated pressures to sell shares. Furthermore, the scramble for liquidity appeared international as "bubbles" were also ending in Amsterdam (Dutch joint-stock insurance companies) and Paris (Mississippi Company). The price of South Sea shares started to decline.

Also in August, the South Sea Company caused a writ to be issued against four companies: York Building, Royal Lustring, English Copper, and Welsh Copper and Lead, charging them with violating the so-called Bubble Act (announced in the Gazette of 20 August; hearings 23 August; see Melville, 1921). They were attracting investors and speculators away from the South Sea Company. Their shares plummeted as a result. However, instead of supporting the South Sea share price, the overall result of the Bubble Act was to critically weaken the South Sea company itself. First, the Sword Blade Company, acting as a banker for the South Sea Company, and perhaps even the South Sea Company itself were susceptible to the Bubble Act. Second, share prices of the bubble companies collapsed, but because these were generally bought on margin or used as collateral, there was also a vicious feedback from strong pressures to sell the shares, the scramble for liquidity and consequently also pressure to sell the shares of the South Sea Company.

[Note: The so-called Bubble Act (Royal Assent 11 June 1720) prohibited any joint-stock company without charters or engaging in activities outside those authorized in its original charter from 'presuming to act as if they were corporate bodies and pretending to make their shares or stocks transferable or assignable without any legal authority'. On 12 July 1720 the Lords Justice ruled on the various petitions for charters and patents of the many bubble companies operating in London and rejected them.]

The decline in South Sea share prices further weakened the financial position of the company because the collection of subscription receivables and loans against share collateral became increasingly doubtful when the contract price was higher than the market value of the shares (especially, when Shea (2004) is correct and investors perceived the subscriptions and share loans as options, rather than fixed debt obligations).

On 24 September the Sword Blade Company suspended payments under pressure from the Bank of England demanding redemption of its notes in specie or in BoE notes. There was a risk that creditors of the Sword Blade would liquidate its loan portfolio and confiscate and sell South Sea stock used as collateral. The South Sea Company had also accepted notes of Sword Blade as payment and could suffer losses. 

In the end, most of the assets of the South Sea Company turned out to be loans and installments due from subscribers into its stock. They were unlikely to be able to meet their obligations. The Bubble Act would prevent the South Sea Company from undertaking investment projects with the available fund of cash.

When the South Sea share price declined, participants in the debt conversion complained and demanded a better deal. The company reduced the conversion share price and reduced the issue price for the latest share issue. The lower issue price also diminished the entire value of the conversion scheme.

In the end, the financial crisis was resolved by writing down assets and liabilities. All remaining shares held by the company were distributed to existing shareholders. As a result the underlying value of the company was reduced to the net present value of the government's annuity payments on the converted debt. The corresponding share price was approx. 100 (par).

 

Conclusion

Events surrounding the rise and fall of the share price of South Sea Company are to a large extent easily explained on the basis of fundamentals. The South Sea Company collapsed due to an unexpected adverse shock (Bubble Act) and a weak financial environment (leveraged positions, caused by installment payments and loans on the security of South Sea shares). There is no reason or evidence to suggest that share prices were simply irrational speculation and merely a reflection of fraudulent stock market manipulation.

Contrary to popular practice, I have not emphasized the many instances of dubious share trading that accompanied the South Sea Company experience of 1720. The fact that many people in high places (directors, politicians and royalty) attempted to benefit from the circumstances does not shed any light on the ex ante rationality of investing in South Sea Company stock. Equally, the fact that many people bought stock with borrowed money (i.e. margin buying) does not shed any light on the existence or non-existence of a bubble. For a large part, the perception of fraud and stock market manipulation is probably due to the usual ex post "blame game" being played after markets crash, when there is enormous pressure on the government to act and compensate investors for their losses. With respect to presumed fraudulent behavior of the South Sea Company directors it has been noted that it is particularly strange that they apparently invested large parts of their wealth in easily confiscated real estate, rather than keeping their profits in liquid assets to facilitate their escape in case of failure of the supposed scheme and to go overseas in order to avoid confiscation. It is perhaps also important to note that at the time of their dealings, the directors probably did nothing illegal as far as the laws of the time were concerned. They were later punished for their failings using new laws that were imposed retrospectively.

 

The South Sea Company's slaving activities

Popular accounts tend to claim that the SSC never realized real commercial activity. Empirical evidence suggests this is simply not true. Helen Paul's article on the SSC slaving activities shows the data on SSC slave ships  (Paul, 2005, Figure 1). The other data show that the SSC did not significantly do better or worse than the Dutch or French companies operating on the same route earlier.

Expectations of the profitability of the slave trade activities were generally high, but the actual profits disappointing, mostly as a result of poor conditions during transport causing people to die. Calculations on the trade show that a small change in mortality rates could have changed the trade in more profitable business.

 

Cross-sectional view on the South Sea Company fundamentals

in a recent study, Frehen, Goetzmann and Rouwenhorst (2009) present an intriguing cross-sectional perspective on the boom in South Sea shares (as well as the so-called 'windhandel' episode in Dutch joint-stock companies during the second half of 1720). They point out that there was apparently a selective boom in share prices of the South Sea Company and the Royal African Company, and also a selective boom in the share prices of the Royal Exchange Assurance and London Assurance. These two distinct share price booms are referred to as selective because no such boom and investor optimism (at least of similar magnitude) is present in the share prices of the East India Company (trading to Asia rather the the Americas) and the Bank of England and Million Bank (being a bank and an investment trust rather than assurance companies). Furthermore, the same cross-sectional difference is also seen in the share prices of the Dutch West Indies Company (WIC, Africa-America) and the Dutch East Indies Company (VOC, Asia). This perspective also sheds a different light on the explosion of new Dutch joint-stock companies founded in 1720, because most of these companies attempted to venture into the joint-stock assurance business. This divergence in share price movements across specific businesses suggests that there is a fundamentals component to the share booms and not simply irrational speculation or fraud.

The data also show that the peak during the boom in share prices was larger in the two assurance company shares than in either the South Sea or Royal African shares. This increases the suspicion that the South Sea Company bubble story has merely become a convenient tool for morality tales about so-called failures of financial markets and the greed and gullibility of financial market participants [i.e. MacKay, 1841] rather than a subject of serious economic analysis.

Note: Data from Neal (1990) datafiles on ESFD and FGR (2009) datafile.

Both Royal Exchange Assurance and London Assurance shares were partially-paid stock, requiring some interpretation. For example, on 1Feb1720 a REA share price of 19 1/2 per ₤100 against ₤10 or 10% paid in represents a full-share equivalent price of 195. The LA (i.e. its predecessor) made additional calls in 1720 going from ₤1 per ₤100 share or 1% to ₤10 per ₤25 share or 40% which requires an adjustment of reported share prices (Scott, 1912; Drew, 1949). The REA (i.e. its predecessor) kept a constant call of ₤10 per share from July 1719, but changed the nominal value of the shares from ₤100 (Royal Mines, 10% paid-in capital) to ₤50 (REA, 20% paid-in capital) in September 1720 and reportedly to ₤20 in October (50% paid in) (Scott, 1912; Supple, 1970). I currently lack the information needed to adjust the reported share prices. From my preliminary calculations I conclude that the LA and REA share prices were very similar once converted to full-share equivalents. Share price data for the LA are currently not shown in the graph.

 

The options feature of South Sea shares

Valuing the SSC shares was already difficult due to fact that the shareholder value depended so much on the uncertain conversion price at which government debt holders would ultimately be willing to exchange their annuities for SSC shares. Another complication is the fact that the SSC shares and subscriptions became effectively options instead of normal dividend paying shares. First, although there is some debate about the formal legal foundations for this (Shea vs. Dale, Johnson and Tang), it is likely that investors considered the share subscriptions to be effectively warrants (i.e. call options issued by the company), because they could walk away from future installment payments at the cost of forfeiting to the company the subscription money they had already paid. Second, by creating a system of loans against collateral for the SSC shares, the company again became a writer of SSC call options, whereby shareholders could default on their loan repayment at the cost of forfeiting the shares they put up as collateral. In both cases, the fortunes of the SSC became very much dependent on the continuing rise of its share price and a positive value for the options. The fragility of this system, well known and nothing extraordinary from a modern perspective, became apparent in the ultimate share price collapse.

[Note: The optional nature of subscription payments was made very explicit in the share subscriptions that appeared in the Netherlands in the second half of 1720. The Dutch subscription prospectuses clearly stated the forfeiture of shares/money paid in case of late payments of installments.]

This payment receipt on South Sea Company shares, dated 15 April 1728, highlights one (happy?) investor who succeeded in paying in full all amounts due on a part of South Sea stock. Comments: (1) These receipts of payments are frequently referred to as shares, but this is misleading. At this time, shares only existed as registrations on the company books (what we today call book-entry securities). It was recommended that (new) shareholders keep the receipts until such time that they were sure their ownership was correctly registered on the company books; then destroy the receipts in order to avoid unnecessary confusion among children and family searching for estate value after ones death. Receipts did not prove actual ownership (Mortimer, 1761 [7th ed 1769]). (2) Shares were only registered as shares after completion of all payments. (3) Shares could refer to various odd amounts of nominal capital, although trading in the stock markets normally assumed and was based on a standard capital amount (i.e. 500 pounds). Some traders specialized in buying odd amounts and aggregating them into standard amounts.

 

The 'Bubble Act'

On 9 June 1720 Parliament passed a bill for the so-called Bubble Act - actually a name attached to this act much later, in the early 19th century - officially named "An Act for better securing certain Powers and Privileges, intended to be granted by His Majesty by Two Charters, for Assurance of Ships and Merchandize at Sea, and for lending Money upon Bottomry; and for restraining several extravagant and unwarrantable Practices therein mentioned." (Note: Royal Assent 11 June; incorporation of the two companies i.e. charters granted 22 June.)

Following the details of incorporation of the two insurance companies, Clause 18 of the Act attached a second act "An Act to Restrain the Extravagant and Unwarrantable Practice of Raising Money by Voluntary Subscriptions for Carrying on Projects Dangerous to the Trade and Subjects of this Kingdom".

Text of this Act reads: "All undertakings . . . presuming to act as a corporate body . . . raising ... transferable stock . . . transferring . . . shares in such stock . . . without legal authority, either by Act of Parliament, or by any Charter from the Crown, . . . and acting . . . under any charter . . . for raising a capital stock . . . not intended . . . by such Charter . . . and all acting . .. under any obsolete Charter . . . for ever be deemed to be illegal and void." (see Harris, 1994)

 

On families, children and other victims

As in almost every case of financial market collapse, critics and persons seeking compensation support their arguments by claiming enormous and ruinous effects on many innocents and the defenseless. In fact, the annuitant subscribers seem to have fared reasonably well, because the effective price at which they obtained SSC shares was relatively low (see Scott, 1912). Victims of the SSC share price collapse were primarily the subscribers to the money subscriptions although they only paid small installments. In this respect, it is perhaps also worthwhile to note that approx. 3 million pound of nominal stock (and probably more) in the money subscription was subscribed by a large number of members of the House of Commons and House of Lords (Scott, 1912).

Also, the other chartered joint-stock companies seem to have held substantial portions of SSC stock, for investment or speculative purposes, creating a direct link between the various London share prices.

 

Postscript

A modern manifestation?

From end-1995 until early-1996 a Canadian mining company called Bre-X Minerals experienced a spectacular rise in its share price. The share price went from little more than a few C$ cents to more than C$ 25 per share. The reason was that the company had announced a large find of gold reserves in Indonesia (promising to be the largest new find of gold in the 20th century). Estimates of the gold reserves increased over time and subsequent reports by mining consultants and the Indonesian Mines Ministry indeed confirmed the existence of the gold reserves. Financial firms such as Lehman Brothers and J.P. Morgan strongly recommended to buy the shares of Bre-X. The share price increased accordingly. Trouble started when the chief geologist of Bre-X went missing and was presumed dead. It turned out that the mining reports were based on "salted" samples and the gold reserves non-existent. The share price of Bre-X Minerals collapsed in the early months of 1997.

Using the benefit of hindsight, some 'experts' may label the Bre-X Minerals case a typical example of irrational investor behavior. However, the fact remains that ex ante, based on what appeared to be qualified and independent reports, rational stock market investors had valid reasons to expect large future profits from this proposed mining operation. They therefore increased the share price of Bre-X, which, according to fundamental finance theory, should currently reflect the expected discounted value of future cash flows.

 

Recent literature

  • Garber, P.M., "Famous first bubbles," Journal of Economic Perspectives, vol.4 (2) Spring 1990.

  • Garber, P.M., Famous First Bubbles: The Fundamentals of Early Manias. MIT Press, 2000.

  • Neal, L.D., "How the South Sea Bubble was blown up and burst: A new look at old data," in E.N. White (ed.) Crashes and Panics. Business One Irwin, 1990.

  • Neal, L.D., The Rise of Financial Capitalism: International Capital Markets in the Age of Reason. Cambridge Univ Press, 1990.

  • Harrison, P., 'Rational equity valuation at the time of the South Sea Bubble,' History of Political Economy, vol.33 (2) 2001: pp. 269-81.

  • Shea, G.S., 'Financial market analysis can go mad (in the search for irrational behaviour during the South Sea Bubble,' Economic History Review, vol.60 (4) November 2007: 742-65.

  • Shea, G.S., 'Understanding financial derivatives during the South Sea Bubble: The case of the South Sea subscription shares,' Oxford Economic Papers, vol.59 Suppl 2007: 73-104.

  • Shea, G.S., 'Arbitrage and simple financial market efficiency during the South Sea Bubble: A comparative study of the Royal African and South Sea companies subscription share issues, working paper October 2007.

  • Shea, G.S., 'South Sea Company subscription shares and warrant values in 1720,' working paper June 2004.

  • Dale, R. J.E.V. Johnson and L. Tang, 'Pitfalls in the quest for South Sea rationality,' Economic History Review, vol.60 (4) November 2007: pp. 766-72

  • Dale, R.S., J.E.V. Johnson and L. Tang, 'Financial markets can go mad: Evidence of irrational behaviour during the South Sea Bubble,' Economic History Review, vol.58 (2) May 2005: pp. 233-71.

  • Temin, P.  and H-J. Voth, 'Riding the South Sea Bubble,' American Economic Review, vol.94 (5) December 2004: pp. 1654-68.

  • Carlos, A.M. and L.D. Neal, "The micro-foundations of the early London capital market: Bank of England shareholders during and after the South Sea Bubble, 1720-25" . Economic History Review, vol. 59, (3) August 2006: pp. 498-538.

  • Harrison, P., "What can we learn for today from 300-year-old writings about stock markets?' History of Political Economy, vol.36 (4) 2004: pp. 667-88.

  • Paul, H., "The South Sea Company's slaving activities,' Economic History Society Annual Conference 2005: pp. 16-22..

  • Nogues Marco, P. and C. vam Malle, 'East India bonds, 1718-1763: Exotic derivatives, efficiency, and the financial revolution,'

  • Neal, L.D., 'Efficient markets in the eighteenth century? Stock exchanges in Amsterdam and London,'

  • Anes, R.D., 'Accounting and slavery: The English company of the South Sea Accounts - First period 1713-1722.

  • Frehen, R.G.P., W.N. Goetzmann and K.G. Rouwenhorst, 'New evidence on the first financial bubble,' Yale working paper no.09-04. Being revised.

Internet

Warning: Many of the websites, weblogs, etc. continue to repeate the popular Mackay version of the bubble stories. It has been clearly demonstrated that Mackay is simply an unreliable source with an over-emphasis on silly stories and with no real attempt to understand or analyze the true events. Any site quoting Mackay as a main source is simply of no value at all.

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