The South Sea Bubble

The South Sea Bubble

Suppose your broker has called you and recommended that you invest in a new company with no sales or earnings – just great prospects. “What business?”, you ask. “I’s sorry,” your broker explains, “no one must know what the business is, but I can promise you enormous riches”. A con game, you say. Right you are, but 300 years ago in England this was one of the hottest new issues of the period. And, just as you guessed, investors got very badly burned. The story illustrates how fraud can make greedy people even more eager to part with their money.

At the time of the South Sea Bubble, the British were ripe for throwing away money. A long period of English prosperity had resulted in fat savings and thin investment outlets. In those days, owing stock was considered something of a privilege. As late as in 1683, for example, only 499 souls benefited from ownership of East India stock. They reaped rewards in several ways, not least of which was that their dividends were untaxed. Also, their number included women, for stock represented one of the few forms or property that females could possess in their own right. The South Sea Company, which obligingly filled the need for investment vehicles, had been formed in 1711 to restore faith in the government’s ability to meet its obligations. The company took on a government IOU of almost 10 million pounds. As a reward, it was given a monopoly over all trade to the South Seas. The public believed there were immense riches in such trade, and regarded the stock with distinct favor.

From the very beginning, the South Sea Company reaped profits at the expense of others. Holders of the government securities to be assumed by the company simply exchanged their securities for those of the South Sea Company. Those with prior knowledge of the plan quietly bought up government securities selling as low as 55 pounds and then turned them in at par for 100 pounds worth of South Sea stock when the company was incorporated. Not a single director of the company had the slightest experience in South American trade. This did not stop them from quickly outfitting African slave ships (the sale of slaves being one of the most lucrative features of South American trade). But even this venture did not prove profitable, because the mortality rate on the ships was so high.

The directors were, however, wise in the art of public appearance. An impressive house in London was rented, and the boardroom was furnished with thirty black Spanish upholstered chairs whose beech-wood frames and gilt nails made them handsome to look at but uncomfortable to sit in. In the meantime, a shipload of company wool that was desperately needed in Vera Cruz was sent instead to Cartagena, where it rotted on the wharf from lack of buyers. Still, the stock of the company held its own and even rose modestly over the next few years despite the dilutive effect of “bonus” stock dividends and a war with Spain which led to a temporary collapse in trading opportunities.

Across the channel, another stock company was formed by an exiled Englishman named John Law. Law’s great goal in life was to replace metal as money and create more liquidity through a national paper currency backed by the state and controlled through a network of local agencies. To further his purpose, Law acquired a derelict concern called Mississippi Company and proceeded to build a conglomerate that became one of the largest capital enterprises ever to exist, even to this day.

The Mississippi Company attracted speculators and their money from throughout Europe. The word millionaire was invented at that time, and no wonder: The price of Mississippi stock rose from 100 to 2, 000 in just two years, even though there was no logical reason for the increase. At one time the inflated total market value of the stock of the Mississippi Company in France was more than eight times that of all the gold and silver in the country.

Meanwhile, back on the English side of the Channel, a bit of jingoism now began to appear in some of the great English houses. Why should all the money be going to the French Mississippi Company? What did England do to counter that? The answer was the South Sea Company, whose prospects were beginning to look a bit better, especially with the December 1719 news that there would be peace with Spain and hence the way to the South American trade would at last be clear. Mexicans supposedly were waiting for the opportunity to empty their gold mines in return for England’s abundant supply of cotton and woolen goods. This was free enterprise at its finest.

Prevision. Illustration by Elena

In 1720, the directors, an avaricious lot, decided to capitalize on their reputation by offering to fund the entire national debt amounting to 31 million pounds. This was boldness indeed, and the public loved it. When a bill to that effect was introduced in Parliament, the stock promptly rose from 120 pounds to 300 pounds.

Various friends and backers who had shown interest in getting the bill passed received as their reward an option with a twist: The individual was granted a certain amount of stock without having to pay for it; it was simply “sold” back to the company when the price went up, and the individual only collected the profit. Among those rewarded were George 1st mistress and her “nieces”, all of whom bore a startling resemblance to the king.

On April 12, 1720, five days after the bill became law, the South Sea Company sold a new issue of stock at 300 pounds. The issue could be bought on the installment plan – 60 pounds down and the rest in eight easy payments. Even the king could not resist: he subscribed for stock totalling 100, 000 pounds. Fights broke out among other investors surging to buy. The price had to go up – and the eager buyers were right. It advanced to 340 within a few days. To ease the public appetite, the South Sea directors announced another new issue – this one at 400 pounds. But the public was ravenous. Within a month the stock was 550, and it was still rising. On June 15 yet another issue was put forth, and this time the payment plan was even easier – 10% down and not another payment for a year. The stock hit 800. Half the House of Lords and more than half the House of Commons signed on. Eventually, the price rose to more than 1000. The speculative craze was in full bloom.

Not even the South Sea Company was capable of handling the demands of all the fools who wanted to be parted from their money. Investors looked for other new ventures, where they could get in on the ground floor. Just as speculators today search for the next Google or the next X-Bray, so in England in the early 1700s they looked for the next South Sea Company. Promoters obliged by organizing and bringing to the market a flood of new issues to meet the insatiable craving for investment.

As days passed, new financing proposals ranged from ingenious to absurd – from importing a large number of jack-asses from Spain (even though there was an abundant supply in England) to making salt water fresh. Increasingly the promotions involved some element of fraud, such as making boards out of sawdust. There were nearly one hundred different projects, each more extravagant and deceptive than the other, but each offering the hope of immense gain. They soon received the name of “bubbles,” as appropriate a name as could be devised. Like bubbles, they popped quickly – usually within a week or so.

The public, it seemed, would buy anything. New companies seeking financing during this period were organized for such purposes as: the building of ships against pirates; encouraging the breeding of horses in England (there were two issues for this purpose); trading in human hair; building of hospitals for bastard children; extracting of silver from lead; and even for a wheel of perpetual motion.

The prize, however, must surely go to the unknown soul who started “A Company for carrying on an undertaking of great advantage, but nobody to know what it is”. The prospectus promised unheard-of rewards. At nine o’clock in the morning, when the subscription books opened, crowds of people from all walks of life practically beat down the door in an effort to subscribe. Within five hours a thousand investors handed over their money for shares in the company. Not being greedy himself, the promoter promptly closed up shop and set off for the Continent. He was never heard from again.

Not all investors in the bubble companies believed in the feasibility of the schemes to which they subscribed. People were “two sensible” for that. They did believe, however, in the “greater-fool” theory – that prices would rise, that buyers would be found, and that they would make money. Thus, most investors considered their actions the height of rationality as, at least for a while, they could sell their shares at a premium in the “after market”, that is, the trading market in the shares after their initial issue.

Whom the gods would destroy, the first ridicule. Signs that the end was near were demonstrated with the issuance of a pack of South Sea playing cards. Each card contained a caricature of a bubble company, with an appropriate verse inscribed underneath. One of these, the Puckle Machine Company, was supposed to produce machines discharging both round and square cannonballs and bullets. Puckle modestly claimed that his machine would make a total revolution in the art of war.

The eight of spades described it as follows:

A rare invention to destroy the crowd.

Of fools at home instead of fools abroad.

Fear not, my friends, this terrible machine.

They’re only wounded who have shares therein.

Many individual bubbles had been pricked without dampening the speculative enthusiasm, but the deluge came in August with an irreparable puncture to the South Sea Company. This was self-administrated by its directors and officers. Realizing that the prices of the shares in the market bore no relationship to the real prospects of the company, they sold out in the summer.

The news leaked and the stock fell. Soon the price of the shares collapsed and panic reigned. Government officials tried in vain to restore confidence, and a complete collapse of the public credit was barely averted.  Similarly, the price of Mississippi Company shares fell to a pittance as the public realized that an excess of paper currency creates no real wealth, only inflation. Big losers in the South Bubble included Isaac Newton who exclaimed, “I can calculate the motions of heavenly bodies, but not the madness of people”. So much for castles in the air.

To protect the public from further abuses, Parliament passed the Bubble Act, which forbade the issuing of stock certificates by companies. For over a century, until the act was repealed in 1825, there were relatively few share certificates in the British market.

Source: Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc