Lessons from the past – The South Sea Bubble and the early days of financial alchemy!

Welcome to Finance and Fury, The Furious Friday Edition

Today – Lesson from the past –

Story of Financial alchemy in its early days

Specifically – turning debt into equity – i.e. financial alchemy

1. Story Starts – In 1700s the English Crown had amassed massive debts – all from fighting wars with the French and Spanish, also a massive civil war – along with colonialist intentions –
2. When in August 1710 Robert Harley was appointed Chancellor of the Exchequer
   1. Position – senior official within the Government of the United Kingdom and head of Her Majesty’s Treasury
   2. When he took over – got a bit of a shock – £5,000 in assets – £9,000,000 in debt – to give an idea of this size – that debt is still being paid down – last announcement in 2015
3. Politically – things were also a mess – At the time – two parties – Tory’s and the Wigs – very bipartisan who couldn’t get anything done – raising taxes to pay this was out – so turned to the Bank of England
   1. The government had already become reliant on the Bank of England – back then up until around 30 years ago – a privately owned company
   2. BOE was chartered in 1694 – chartered 16 years previously by the Wigs, which had obtained a monopoly as the lender to Westminster – in return for arranging and managing loans to the government
   3. But in this time period – the Tory party was in power – so the Wig controlled BOE was offering massive rates – and the government had become dissatisfied with the service it was receiving and Harley was actively seeking new ways to improve the national finances
   4. Couldn’t raise funds from other European nations – was at war with most – so turned to John Blunt – was a crafty man
4. Blunt saw this as an opportunity to make himself filthy rich – dreamed up a scheme –
5. Back Story on Blunt – Before this moment in time – Blunt had a company Hallow Sword Company – monopoly of selling swords to Gov and the army –
   1. Cooked up a scheme in the past – wanted to buy land in Ireland which was owned by the government – but needed funds – so he had a plan – trade share in hallow sword company at under market value for army debentures (debt) – but can’t repossess the debentures – so made them technically worthless – but knew that the offer to do a swap at under market value would be massively in demand – and increase the price of the army debentures – so before he announced this scheme – he went out and bought massive amounts of these army debentures –
   2. Then he announced so the value of the debentures went through the roof due to people trying to get them to trade for his companies shares – then could trade the technically worthless debentures back to the government for the land that he wanted in Ireland – this was technically illegal – but he was lending the government money – so no action was taken in the end
      1. Similar to the bankers doing swaps on CDOs in the GCF – anyway
   3. As blunt was helping the government – Harley had his man – as he needed funds –

Came up with the South Sea Company 

(officially The Governor and Company of the merchants of Great Britain, trading to the South Seas and other parts of America, and for the encouragement of fishing)

1. Was a British joint-stock company founded in 1711, created as a public-private partnership to consolidate and reduce the cost of the national debt
2. How? Made a plan – the trading company – Scheme would be similar to what blunt did with his own company –
   1. Anyone who held Government debt would be able to trade the debt for shares in the SSC – then Government would pay the SSC 6% interest on the debt they took over – about £500,000 p.a.
   2. To make it enticing – South Seas Co was given monopoly on trading in south seas – and tried to get hype around the shares – convincing that the shares in the company were going to skyrocket – here was a chance to make millions – the term millionaire was coined in this time period with the SSC stock rising – which happens later in the story
   3. East India Company was doing well – and public perception was that the SSC company was going to boom like the EI company
   4. But the promise of the trading profits of the SSC was a scam though – South America was run by the French and the Spanish who the British were at war with – needed peace – but the majority in the house of lords didn’t want this
3. Queen Anne was approached by Harley and Blunt – and got 12 more lords in the house of lords – lords was all it took – no voting – blunt got Queen Anne to push through these lords to get a majority vote for peace – but the peace deal only let 1 ship a year into the ports – but the public was never told –
   1. Had famous authors and others push the scheme still
4. 1714 – King George took over with Anne’s death – But the wigs took over at the same time – so Tory’s no longer in power – and Harley was kicked out – so Blunt took action – Got the king to invest into SSC – forgave two years worth of interest payments that they owed – but in return – was allowed to issue more shares in the SSC
   1. 10,000,000 of new stock was issues – which was massive – half the size of all the companies shares in the whole of Britain – this on a company that to date- had only lost money on trading
   2. This Convinced the government to continue to offload more government debt to the company – as they now had more shares to offset it –
   3. Put in perspective – say today that one company was half the size of the ASX but with no income (only losses) – the Government just turned around and made it bigger by trading more of their debt with it (Government bonds)
5. 1717 – King became the SSC leader – company became too big to fail – if the company failed – prestige would fail –
6. From around 1719 – the shares in the SSC started rising £100 to £114 pretty quickly – the previous agreement was that the market cap (number of shares to the share price) had to be equivalent to the government debt – £100 of equity for £100 of debt – almost the same to banks today – look at their financial sheets – the assets and liability offsets
   1. But at a £14 difference in price rise – the company could sell these shares at a profit and pocket the difference – as with this price rise they didn’t take on any new debt
   2. Gave Blunt ideas – the company still wasn’t making money remember –
   3. Now decided to take on the £31,000,000 debt the government racked up by 1719 – if successful – make the SCC he biggest financial institution in the world –
   4. But Needed to convince the Gov to let them take over the debt – so to convince in this case was to bribe – with about $2m each today worth of bribes – But still wasn’t enough – as the BOE was also another contender to sell the debts to and the Wigs were favouring this – so offered them shares in the SSC –– In the end – SSC got the rights to consolidate the government’s debt – Share swaps took place
7. But the effects of public officials getting into the shares and King George taking over leadership of the company gave the public the perception that the shares must be a good thing – a lot of confidence in the shares
8. Within a few months the share price rose to £330 – but the next month the shares went down to £310 – which wasn’t good news – remember – this company didn’t make money – the only way to make money for investors was a price rise from speculation – or more irrational purchases –
9. The share price couldn’t decline otherwise the scam would be up – So Blunt Came up with a new scheme – buy the shares with 20% down and regular payments every 2 months (similar to how warrants work today) – created leverage on leverage – allowed people to buy way more than they could afford –
   1. Could buy 5 times the number of shares today with only 20% down
   2. But as long as stock prices went up – people could sell a small amount every 2 months to fund their next repayment on the shares – the amount of leverage went to on average 5 times the amount of shares compared to the money they had in the bank
   3. Created further greed in the market – When people profited or others felling like the missed out – they bought more stock
10. The new scheme worked – Price quickly rose to £550 – but then soon after prices dropped again to £510 –
    1. Remember – this cant happen otherwise the scheme would go bust – very leveraged and driven by greed – if people saw the price go down then people may stop buying
11. Blunt came up with the Next scheme – Loan people the money to buy the shares – loans from SSC to individuals – then they would buy their own shares back off them and push the prices higher
    1. Prices went to £600 – seeing this – people wanted to get in – greed took over rational sense – even Isaac Newton wanted to get in – buying massive amounts of shares – about £20,000 worth which he lost in the end
12. All of this had another unintended effect/consequence – others started their own share scheme – started popping up everywhere – crazy ones – like flying machines – so money going into SSC started to cease – as other schemes which people thought could make them more money instead were starting to take off –
    1. Similar to Crypto – BTC did so well so others pumped money into it – then all of a sudden new coins emerged – so the money started to flow into these as well
    2. But in England at the time – not enough money in the whole country to prop up prices – so the Bubble Act was put into place in 1720 – which forbade the creation of joint-stock companies without a royal charter, was promoted by the South Sea Company itself before its collapse.
    3. Essentially the banning of every other scheme except the SSC – but due to this act – had opposite effect – which was those who invested in the now banned schemes lost their money – so had to sell their SSC stock to make it up – as they were otherwise broke
13. Prices initially Dropped for the SSC – But no rivals on the market – so shares in one week went from £503 to £830 due to removal of other share schemes –
    1. But remember – this company was highly leveraged – not making any money – company valued at £300,000,000 – almost 10 times the size of the £31,000,000 pounds of government debt that the valuation should have been based around – all the money in Britain was around £60,000,000 –
    2. Based around current markets – would be $85trillion USD – which sounds huge – but derivative exposure dwarves this today
    3. All of a sudden – prices started to decline – so blunt started to issues more shares- at £1000 per share – offering more incentives – 10% upfront with no payments for a year –
    4. Hype was so strong – sold straight away – those who bought early made massive amounts of money
    5. It was at this point that Blunt and a lot of politicians then he sold off a lot of their shares – the bubble was about to burst – The top of the market at £1,000 – created a massive sale for profit taking – those who bought the shares with 20% down at £500 – or earlier
14. What broke the bubble – Blunt offered a 30% p.a. dividend – which woke up the people – losing confidence – fell hundreds of pounds –
    1. In 3 weeks – went from over £1,000 to £150 – bankruptcies and suicides were rampant
    2. But what happened – bailouts – bank of England and East India company share swaps – by Walpole – which is another story
    3. The economic effects were widespread –

What does this all have to do with today?

1. Greed – bubbles, BTC, leverage, Corporate debt fuelling markets – Central banking policies – fuelling markets with leverage
2. Political bribes and self-interest as well –
3. Cover this in another episode

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