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Bubbles Part II

By: Jim Mosquera | Tuesday, April 15, 2014

In the previous article, I discussed one of the first documented examples of bubbles and a dramatization of a bubble with a St. Louis sports flavor. This time I discuss another bubble, not involving flowers, the South Sea Bubble of 1711-1720.

The English government had a debt of £10 million and convinced the holders of this debt to exchange it for stock in the South Sea Company (SSC). The government granted this company exclusive trading rights in Spanish South America. The plan was for government to give the company a perpetual annuity of some £576 thousand. The holders of the government debt (now holders of South Sea Company stock) were assured of a steady stream of income in their new company. The government would apply a tariff on goods brought from South America in order to pay the annuity. On the surface, it seemed like a fine arrangement.

During this time of English affluence, investors sought new avenues for their funds. The SSC was such a viable avenue. The cozy arrangement between the government and the SSC seemed like a sure thing. The English would trade wool and fleece for jewels and gold. Additionally, the SSC was heavily in the slave trade, resettling people from West Africa into the Americas. It was reasoned that the trade monopoly the SSC had in South America was a "can't miss" proposition.

The operators of the company projected affluence and thus investors sought more company ownership. The company engaged in a great deal of self-promotion by creating rumors inclined to increase the price of their stock. The market also understood there to be a deal in place between government and the SSC that included a multi-million pound line of credit for potential expansion. In an early, quasi-example of company-issued stock options, lucky recipients received stock, for which they paid nothing, and later sold the stock back to the company at a profit when the price increased. This arrangement created a moral hazard for stock owners (government officials included in this group) whose interest it was to increase the stock price. Eventually, SSC's stock price climbed 10-fold.

The popularity of the SSC created a speculative frenzy in other stocks as well. In Charles Mackay's book, Extraordinary Popular Delusions and the Madness of Crowds, one company was formed:

"for carrying out an undertaking of great advantage, but nobody to know what it is."

It takes a lot of chutzpah to form a company and not declare its purpose. As a point of reference, companies of dubious value appeared prior to the U.S. stock market top of 2000.

New investor purchases erupted with money borrowed from banks. This action created previously non-existent demand. The SSC injected even more speculative fuel through investor loans to buy its shares. The result of the bank and company loans was a higher stock price.

There is a contrary theory on investor sentiment, which to paraphrase says that when the market has too much optimism, there are few new buyers left and only downside potential exists. That condition materialized in this market. After reaching a 10-fold increase in price, a wave of selling began. The selloff's initial wave can be for a variety of reasons. The herding instinct, so prevalent in the early stages of the mania, dissipates. Sellers, who had earlier purchased shares with borrowed money or on credit from SSC, saw the value of their investment dip. Leveraged purchases are often at great risk for initial selling as lenders see the value of their collateral (in this case SSC stock) decline in value. The leveraging evident with SSC stock occurred elsewhere and soon other stocks began their decline as well.

The stock's fall caused failures in the banking industry, as loans made to investors for stock purchases were uncollectible. Goldsmiths, another industry extending credit for stock purchases, experienced similar calamity. The collapse of the stock's price led to financial ruin not just for banks and goldsmiths but prominent citizens as well. With investor outrage at a fever pitch, the English Parliament convened to investigate the matter. Measures were taken to restore public confidence. Eventually the Bank of England (the British version of the Federal Reserve Bank) stepped in to buy stock in the SSC. The government also decided to take legislative action to prevent such a bubble from occurring again. Does any of this sound familiar? A simple substitution of names and you have the financial crisis of 2008.

There is nothing intrinsically wrong with investors bidding up the price of SSC stock. At some point, the value of the stock reached a level that encouraged more risk-taking in order to create greater public participation. It is the heightened risk-taking that exacerbates the bubble.

In the next article, the final in my three part series, I will delve into the anatomy and consequences of a bubble.

 

Author: Jim Mosquera

Jim Mosquera,
The Sentinel

Jim Mosquera

Jim Mosquera is a Principal at Sentinel Consulting and is the author of E$caping Oz: Protecting your wealth during the financial crisis.

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