1720
The South Sea Company bubble

Founded in 1711, The South Sea Company is a British Joint Stock Company which spawned out of a £10 million government debt which it later converted into shares. The company’s takeover of this huge government debt gave them a trade monopoly with the Spanish colonies which includes the rights to sell slaves and a yearly interest payment from the British government. During that era, the sea around South America was dubbed as the South Seas and the nature of trade that the company will undertake gave the name the South Sea Company.  Although the company always registers trading losses on its balance sheet, the South Sea Company receives annuities from the British government because they take over government debts. These debts were converted into South Sea shares which are then sold to investors. This scheme technically transferred government debt which the company took over to the buyers of their shares while they still collect annuities from the British government.

Instead of a company trading commercial goods at a profit, The South Sea Company depended on the sale of its shares and government annuities for profit. The scheme that they undertook was complex for an average citizen at that time and the plan was to take over government debt to receive yearly interest payments and if they could inflate their share price, it can also be booked as profits.

As an incentive for holders of British government annuities to convert it to South Sea shares, the face value of the government bonds has to be less than the price of South Sea shares. This means that the South Sea shares had to rise or if it doesn’t naturally do so, it will be inflated artificially. The company was allowed to issue 315,000 new shares at a face value of £100 per share. At this face value the company can raise a total of £31.5 million. If the government debt is at the same level, the South Sea company would have no surplus shares to sell for profit. However, this would work if the share price can be inflated to twice its face value. At £200 per share, the company would only have to pay holders of annuitants half of the total number of shares and the rest could be sold in the stock market as profits.

Fortunately for the company, France is undergoing a financial revolution with John Law at its helm in 1719. With John Law’s innovation of paper money as a medium of exchange instead of a store of value, the excess flood of money from the French asset price bubble has found their way into the British financial system. This newly available capital supported the steadily rising share price of South Sea Company. Just like the Mississippi Company in France, Britain now entered into a mania. As more people are attracted to the share market, newly formed companies formed overnight and also floated their shares in the market. The South Sea Company issued additional shares for profit as it took advantage of the stellar rise in price of its stocks. As expected under a mania, the shares were sold out within hours of its public offer. The company also provided subscription terms or installment terms to acquire shares that are very attractive to interested buyers of the stock, they only need to make a 20% down payment and the remainder will be paid in increments within a 16 month period. The deposits paid for these subscriptions are then used to make loans to people and make a profit from interest. The company has turned from company trading merchandise from the South Seas into a financial firm since most of their profits are coming in from financial activities instead of from the trade of goods.

The company kept on issuing new shares without the effect of share price dilution. This is due to the fact that the country is under a financial mania. That people always become irrational when confronted with easy and quick gains. The entire country is now under a financial bubble, started by the South Sea Company and partly jolted by the activities in the French financial system. Since there are now numerous bubble companies competing with South Sea shares, the crash is about to unfold as prices become so high and unsustainable. The fact that banks make loans using shares as collateral, in the event when share prices decline, the collateral used for the loan will be now be worth less than the loan amount. If a debtor defaults, banks would suffer a loss since the collateral used cannot cover the amount of the loan. This is exactly what happened to the Sword Blade bank, South Sea Company’s bank has failed. The bank made extensive loans against South Sea shares and as the shares go down so as the bank’s assets.  The bursting of the South Sea bubble can be traced down to France where most of the investment capital came from due to the expansionary monetary policies by John Law. At this same year in 1720 France also suffered the same financial meltdown but in this side of the channel, it was a lot bigger.













Stocks | Forex | Options | Economics | Bonds | History | Language learning | Technology | Technical Analysis | Fundamental Analysis
Copyright © 2014 econtrader | Risk disclosure | Terms of Use