Most people will take risks to earn money quickly and easily. So, when a seemingly too good to be true investment opportunity comes along, we are tempted to jump on it. And of course, when something seems too good to be true, it probably is. A great historical example of that is the South Sea bubble.
The South Sea Bubble was a speculative bubble during the 18th century. It involved the shares of the South Sea Company which was a British international trading company. What happened was the stocks in the South Sea Company were traded for 1,000 British pounds. In the half of 1720, they were reduced to nothing, and a massive amount of money was lost.
But how do you think did the South Sea Bubble started, and why did it pop? If you’re curious, read on to know more about the South Sea Bubble.
How Did the South Sea Bubble Begin?
In 1711, the South Sea Company was founded by the Lord Treasurer Robert Harley, and the former director of the Sword Blade Company, John Blunt. In this period, most of the Americans were being colonized. The Europeans used the term “South Seas” in reference to South America and other lands located in the nearby waters.
During the ongoing War of Spanish Succession of 1701 to 1713, Robert Harley was responsible for creating a mechanism used to fund the British government’s debt that was being gained. However, Harley was unable to establish a bank because the Bank of England’s charter established itself as the only joint stock bank. Undeterred, what he did was he established what appeared to be a trading company but its primary business activity was funding government debt.
The British government thought that offering exclusive trading rights with Spain’s colonies was an effective incentive to convince the private sector to assume the war debts of the government. The South Sea Company and the government convinced shareholders to assume a total of 10 million pounds in short-term government debt in exchange for South Sea Company Shares. The government gave shareholders a continual annuity in return, paying a total of £576,534 each year, or a continuous loan of £10 million at a 6 percent yield. This deal led to a steady flow of earnings for new shareholders. The government then placed tariffs on goods that were imported from South America which was intended to fund interest payments.
In 1713, the peace Treaty of Utrecht was signed at the end of the War of Spanish Succession and the South Sea Company’s trading rights were finally put into writing: the right to provide the Spanish colonies with slaves and to send one trading ship per year. However, these formal trading rights were a disenchantment to Robert Harley because they were nowhere near as extensive as he had originally expected when he founded the company in 1711.
The South Sea Company had assumed an additional £2 million worth of government debt by 1717. By then, the spending of the government for the United Kingdom had reached £64.4 million, which the government was able to afford through lowering the interest rate on its debt. During this period, the shareholders in the South Sea Company continued to collect a reliable stream of earnings.
A proposal was made by the South Sea Company in 1719 in which it would purchase over half of the British national debt with new shares together with a promise to the government that the interest rate in the debt would be reduced to 5 percent until 1727 and 4 percent for every year after that. This refinancing scheme enabled the illiquid high-interest debt to be converted into highly-liquid low-interest debt which was a win-win situation for all parties involved.
The government was in debt by £50 million as of 1719 where £18.3 million of which was held by the three largest corporations in England. One of those corporations was the Bank of England which owned £3.4 million of that total debt. The other corporation was the British East India Company that owned £3.2 million while the remaining £11.7 million was owned by the South Sea Company.
During the Bubble Phase
The trading rights of the company with Spanish colonies were fairly modest, however, its executives honed the investors’ appetites by telling them incredible tales and rumors of South American gold and silver that were just waiting to be imported back to Europe. In 1720, the company has successfully sparked a speculative rage for its shares, with stock prices rising from £128 in January, £175 in February, £330 in March, and £550 in May. Thanks to a £70 million fund of credit by the King and Parliament for the purpose of commercial expansion, the company was able to support unusually high valuations.
Numerous politicians were offered shares at market prices but they did not purchase the shares in a conventional sense. Instead, they held on to their shares with the option to sell them back to the South Sea Company at a later date which allowed them to keep all profits made. A lot of government employees and as well as the King’s mistress were enticed by this purchasing agreement. The value of the South Sea Company shares was pumped with the help of high ranking shareholders in addition to lending an air of legitimacy to the scheme.
The South Sea Company shares bubbled up to incredible new heights. There were numerous other joint-stock companies who took advantage of the booming investor demand for speculative investments. A lot of these new companies made extreme and often fraudulent claims about their business ventures to be able to raise capital and boost their stock prices. Some of these proposals were, for trading in hair, for insurance of horses, for improving gardens, and the most outlandish of all is the one for carrying on a commission of great advantage, but nobody knows what it is.
These highly speculative companies were called “bubbles”. In order to control them, a Parliament was passed in 1720 which was the “Bubble Act” that required new joint-stock companies to be incorporated. In June 1720, ironic as it may seem, the passing of the “Bubble Act” caused the South Sea Company shares to rise to £890. During this period, a full-blown speculative fury developed in all “bubble” company shares and all classes of British society took part in the action. The poor people went from rags-to-riches overnight as share prices ballooned to greater heights.
How Did the South Sea Bubble Pop?
Even though the shares of South Sea Company were skyrocketing, the company’s cost-effectiveness was average at best regardless of the abundant promises of future growth by company directors. By August 1720, shares leaped to £1000 per share and finally peaked at this level before falling and triggering a landslide of selling. John Blunt had instituted earlier in the year the selloff in Company shares for the purpose of boosting share prices. This plan needed the South Sea Company lending investors’ money to buy its shares, meaning, a lot of shareholders had to sell their shares to cover the plan’s first installment of payments that were due in August.
Speculators who had purchased shares on credit went bankrupt in short order as South Sea Company and other “bubble” company share prices crashed. When the South Sea Bubble popped, it resulted in a contagion that popped a coexisting bubble in Amsterdam as well as France’s Mississippi Scheme bubble.
In September 1720, the South Sea Company share prices hit a pitiful £150 per share. With this, banks and goldsmiths went bankrupt because they were unable to collect loans that they had made to both recently-bankrupted common folk and aristocrats alike. In fact, even Sir Isaac Newton lost £20,000 fortune in South Sea Company shares. That is equivalent to about £268 million in present-day value. It caused him to say that he can calculate the movement of the stars, but not the madness of men.
In December 1720, the outrage of the investors led Parliament to open an investigation into the matter. It resulted in a report that revealed extensive fraud as well as corruption among members of the Cabinet. John Aislabie, Chancellor of the Exchequer at the time of the South Sea Bubble, was imprisoned and the rest of the members of the cabinet were impeached. The shares that were left on the South Sea Company were issued to the Bank of England and the East India Company.
Investing is very risky. In fact, things like the South Sea Bubble are still happening to this day because there are a lot of scam companies out there who would show you wonderful results (true or not) just to convince you to invest so be careful.