FAMOUS FIRST BUBBLES? -- SOUTH SEA BUBBLESourceThe 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 by the Bank of England and the New East India Company). This South Sea Company 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 576,534 pounds 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.
Initial equity for the South Sea Company had come from conversion of short-term government debts into shares of the new company. 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.
In March 1720 Parliament passed a bill 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 approx 1.3 mln in bribes). To finance the debt acquisition, the company was permitted to expand the number of its shares. Despite some objections, the company was 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 and finally collapsed from about 775 on August 31 to about 290 on October 1.
FundamentalsCrucial to the 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. 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. Other assets and liabilities were
net present value government annuities --- 40 mln
plus loans to stockholders --- 11 mln
plus installments due from cash subscribers --- 70 mln
less payment of conversion privilege --- 7 mln
less debt in bonds, bills --- 6 mln
total value --- 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 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.
One option is to call the previous valuation gap of 60 mln pounds the bubble component of the South Sea share price. However, can there be a role for intangible assets to close the valuation gap? 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 3 mln on investment of 70 mln (or 4% ROI) would close the gap in fundamental value (3/0.04 =75 mln)!
Financial panic and price collapseIn August the first of the installment payments of the first and second money subscriptions on new issues of South Seas stock were due. Probably, 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 and Paris. The price of South Sea shares started to decline.
Also in August, the South Sea Company invoked a writ against York Buildings Company and New River Company, charging them with violating the Bubble Act (enacted in June, prohibiting any chartered joint-stock company from engaging in activities outside those authorized in its original charter.) They were attracting investors and speculators away from the South Sea Company. However, the Sword Blade Company, acting as a banker for the South Sea Company, and even the South Sea Company itself were also susceptible to the Bubble Act.
In 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 Sword Blade would liquidate its loans 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. The Bubble Act would prevent the South Sea Company from undertaking investment projects with available cash.
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.
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 to suggest that share prices were simply irrational.
NoteContrary 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) turned out to have 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.
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 of 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 in the stockmarket. However, the fact remains that ex ante, based on what appeared to be qualified and independent reports, rational stockmarket 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.
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.
Neil, L., The Rise of Financial Capitalism: International Capital Markets in the Age of Reason. Cambridge Univ Press, 1990.
Internet
* The South Sea Bubble, History House stories. A repeat and summary of MacKay's, Extraordinary Popular Delusions & the Madness of Crowds
* The Bubble Project, David McNeil Dalhousie Univ. A research initiative on the subject of the South Sea Bubble (SSB)