The First Crash: Lessons from the South Sea Bubble by Richard Dale

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The Notes

• “The unaccountable frenzy in stocks and projects of this year 1720 may by some be thought to have taken up too much room in this work: but we are persuaded that others of superior judgement, will approve of the perpetuating…the remembrance thereof, as a warning to after ages.” — Adam Anderson, former South Sea Company clerk, 1764
• Life in 1700 England
  • Average life expectancy was under 20 years of age (author’s guesstimate).
  • Half the population was under the age of 21.
  • Smallpox, typhoid, typhus, dysentery, and tuberculosis were common and incurable.
  • The Great Plague was seared in people’s memory (1665-66).
  • War was common. Four years of peace was sandwiched between the Nine Years War (1688-97) and the War of Spanish Succession (1702-13).
  • Invasion by the Pretender to seize the monarchy and civil war was ever-present.
  • Only 1 in 6 adult males could vote.
  • Lower class annual income ranged from £15 to £50. Merchant class income ranged from £200 to £400, with an estate between £5000 to £15,000. Higher end merchants could earn over £5,000 per year with an estate over £100,000.
  • “A career committed to the laborious acquisition of wealth over time was perhaps less appealing than taking a chance on some get-rich-quick commercial venture. One manifestation of this “short-termism” was the passion for gambling displayed by all classes of society, which successive governments exploited through state-run lotteries that raised funds for the war effort.”
  • London
    • London had a population over 500,000. The 2nd largest town was Norwich at 30,000.
    • Was rebuilt after the Great Fire of 1666.
    • Lombard Street was venue for commodity, money, and ship-broking markets.
    • Royal Exchange opened in 1570 but overflowed into coffee houses and streets by 1700, known as Exchange Alley.
    • It was faster to get from London to Amsterdam or Paris by ship (2 days) than London to Newcastle (9 days).
• Markets in 1700
  • Lombard Street was the center for commodity, money, and ship-broking markets.
  • First Royal Exchange opened in 1570 but by 1700 trading spilled into nearby streets and coffee houses known as Exchange Alley.
  • Coffee Houses
    • Over 2,000 coffee houses in London by 1700.
    • Served 4 Functions:
      • Main source of political, economic, and financial information. Some coffee houses published their own newspapers. Others acted as makeshift libraries providing periodicals and journals to clients.
      • Was part of the Penny Post service started in 1680 for mail delivery and collection. Continued to be used even after the government started its own postal service two years later.
      • Trading companies and other businesses used them for informal offices and meetings and business transactions. Ex: Lloyds Coffee House became the headquarters for marine underwriters.
      • Securities trading.
    • “the Monied Man goes among the brokers (which are chiefly upon the Exchange, and at Jonathan’s Coffee House, sometimes at Garraway’s and at some other Coffee Houses), and asks how stocks go?” — John Houghton, 1694
    • Jonathan’s Coffee House and Garraway’s were the main trading places during the South Sea Bubble. Jonathan’s became the site for the London Stock Exchange.
    • “Every person who enters Jonathan’s to do any business there pays 6d at the bar, for which he is entitled to firing, ink and paper, and a small cup of chocolate; and if he understands the business, is as a Broker for that day (at least for his own affairs) as the best.” — Thomas Mortimer, Every Man His Own Broker
  • Financial News
    • The number of newspapers and trade publications grew after the Licensing Act expired in 1695.
    • Trading companies used newspapers to inform shareholders with press releases and other information.
    • Stock prices were quoted in several papers by 1720, with the earliest in 1681.
    • John Castaing’s “The Course of the Exchange” published a twice-weekly stock and commodity prices of the last three days. It became the official price list of the London Stock Exchange.
    • Despite the increased information access, significant time lag existed between an event and the spread of information, between rumored events and verification, and when information was received by insiders vs. outsiders.
  • Attempts to manipulate prices with fabricated rumors and false reports was common. Most were blamed on stockjobbers.
  • Ex: “A report (later discredited) of Jacobite disturbances in Scotland evidently prompted a 10 percent one-day fall in South Sea stock in February 1720.”
  • Stock Jobber = “A low wretch who gets money by buying and selling shares in the funds.” — Dr. Johnson’s Dictionary, 1755
  • Government Debt Market
    • Preceded equity markets.
    • England’s national debt exceeded £50 million by 1720, in mostly short-term loans.
    • Government debt was not viewed as risk free:
      • Stop of the Exchequer — Charles II defaulted on payments in 1672 and led to 50% write-off of debt.
      • The threat of a Jacobite challenge to throne meant a successful challenge would renounce prior debt incurred by previous monarchy.
      • Timing of interest and principal payments was “patchy” and “often highly uncertain.”
      • Threat of war was constant and carried a potential funding crisis.
      • Tax revenues were increasingly used toward interest payments alone — over 50% from 1714 to 1717.
    • “Long-term fund raising in the 1690s and early 1700s included a ”tontine’ loan, various lottery loans, and the sale of annuities, the latter involving the exchange of a sum of capital, paid from creditor to debtor, for a future income stream from debtor back to creditor.”
    • Liquidity risk for lottery loans and annuities were high.
    • To remove liquidity risk, the government gave monopoly trading and commercial rights to state-sponsored companies in exchange for loans to the government. Shares in the companies could be actively traded. It was a debt-equity swap.
    • “The East India Company and the Bank of England were given their charters in the 1690s on the above basis, in consideration for which the government received initial loans totalling £3.2 million at 8 percent, later reduced to 5–6 percent. Further loans were extracted from the two companies in 1708– 1709 in return for renewal of their charters and privileges.”
    • The South Sea Company would be the third.
  • Stock Market
    • A boom in joint-stock companies occurred from 1690 to 1695, at least 140 companies with total capital of £4.25 million.
    • The big three were the East India Company (founded in 1600), the New East India Company (1698), and the Bank of England (1694).
    • Brokers charged a 0.5% commission per transaction. Shares could also be bought directly in coffee houses to avoid the fee.
    • “By the early 1700s the stock market had become a hybrid regime, with brokers increasingly acting as principals and trading on their own account.”
    • Transactions needed to be recorded on the company’s books for dividend payments.
    • “Investors in the stock market could undertake five types of transaction of varying sophistication:
      • spot transactions for immediate delivery of shares;
      • ‘time bargains’ for future delivery and settlement (‘forward’ contracts in today’s parlance);
      • ‘refusals’ or call options which allowed the purchaser to buy (but also to ‘refuse’) stock at a stated price at some future date in return for payment of a premium;
      • ‘put’ options which allowed the purchaser to sell stock in a similar manner; and
      • simultaneous buy/sell or sell/buy transactions which today we would call repurchase agreements or ‘repos’.”
    • Margin lending — investors could borrow up to 80% of the value of the shares.
    • Investors were typically of the merchant and professional class in London. No institutional investors existed.
    • There was no centralized price source. Investors could find different prices at different coffee houses in Exchange Alley.
    • Regulations
      • Regulations first appeared in 1697 limiting the number of brokers to 100, be licensed by the Mayor of the London, prohibited trading their own accounts, and limited commissions to 0.5%. The rules were rarely enforced.
      • “Any impudent imposter, needed only to hire a room at some coffee house or other house near [Exchange] Alley, for a few hours, and open a subscription book, for somewhat relative to commerce, manufacturing, plantation, or some supposed invention, either newly hatched or out of his own brain, … having first advertised it in the newspapers the preceding day, and he might, in a few hours, find subscribers for one or two millions … of imaginary stock.” — Anderson, 1764
      • Bubble Act of 1720 restricted new issues but was ineffective.
  • Investments Yields of 1700
    • Goldsmith banker deposits — maximum of 6% yield.
    • Land — 5% yield (higher on leaseholds and long-term tenancies).
    • Government annuities — 6% to 7% yield.
    • Short-Term Government Tallys — up to 11% yield.
    • Corporate stocks — 7% to 8% dividend yield.
    • Valuation Methods of the Time
      • Interest or Dividend Yield
      • Relative Valuation using a giving multiple.
      • Present Value calculation
• John Blunt
  • Was a key adviser to the government on lottery loans and came up with the idea for a debt conversion scheme that led to the South Sea Bubble.
  • He launched the “Two Million Adventure” in 1711. It offered a minimum 6.5% return to ticket holders but included five stages of drawings with an increasing maximum prize of £1,000, £3,000, £4,000, £5,000 and £20,000. The Sword Blade Company marketed and distributed £2 million in tickets. Borrowing cost to the government was 8% per year.
  • “The distemper of the times, which captivated the reason of mankind in general, no only in England but in all the neighbouring countries; who leaving the usual methods of labour and industry to gain estates, were all tainted with the fond opinion of being rich at once, which caused many persons to engage much beyond their fortunes, not only in South Sea stock, but in every pernicious bubble that could be devised.” — John Blunt, 1732
  • Blunt took advantage of his insider knowledge. He bought government at a deep discount ahead of announced South Sea conversion schemes, he gave himself excess stock during conversions when the stock rose in price, he sold stock forward after the third conversion, He bought call options before the dividend raise was announced. He bought a fortune of £187,000 on a salary of a few hundred pounds.
• Sword Blade Company
  • Established in 1691 thanks to a £50,000 loan to the government.
  • Made French-style grooved sword blades.
  • Was basically defunct by 1700.
  • Elias Turner, Jacob Sawbridge and George Caswall bought control of the company to use a a shell company.
  • John Blunt joined them around 1703.
  • They used the company for land speculation in 1702:
    • Exchanged new company stock for army debentures then used to buy land.
    • The army debentures were priced at 85 (a 15% discount). The company stock was priced at par or 100. The trade made sense so long as company stock never dropped below 85.
    • They paid £200,000 for confiscated Irish estates with £20,000 in rent — a 10% yield.
    • “They were evidently able to engage in large-scale insider trading, acquiring depreciated army debentures before the conversion offer was made in the knowledge that they would later be able to convert at par or sell on the market when the price rose in anticipation of conversion.”
    • Issues around legal title to the estates, led to company to sell the land and unwind the company.
    • The debt-equity conversion scheme was a success and became the idea behind the South Sea Company.
• South Sea Company
  • John Blunt proposed the company to Prime Minister Harley in 1710.
  • Established September 8, 1711.
  • Authorized by Parliament.
  • The government used the company to stabilize its debt structure and strengthen its credit rating.
  • Initial Assets
    • A trading monopoly on “the kingdoms, lands etc of America, on the east side from the river Aranoca, to the most southern part of the Terra del Fuego, on the west side thereof, from the said most southern part through the South Seas to the most northern part of America, and into unto and from all countries in the same limits reputed to belong to the Crown of Spain, or which shall hereafter be discovered.”
    • £568,279 annual payment from the Exchequer (6% on £9.5 million of short-term government debt secured through a debt-equity swap. Holders of government debt could convert said debt for South Sea shares). The 6% interest was meant to be paid as dividends twice a year to shareholders.
  • “The new company’s authorized equity capital was limited by statute to the amount of government debt that was converted.”
  • The charter was modeled after the Bank of England:
    • Required governor and directors to own a minimum of £5000 and £3000 in stock, respectively.
    • Shareholders with at least £1000 in stock could vote for governor and directors.
    • Voting rights were graduated based on the size of investment, up to a max 3 votes for £10,000 of stock.
    • Blunt added a provision that “gave committees of directors authority to act in any matter entrusted to them ‘as fully as the Court of Directors might do,’ an authority that could be used to bypass the full board when, as later occurred, the affairs of the company came to be managed by a small group of directors operating through a committee structure.”
  • First Conversion
    • Was a direct swap: £100 in government floating debt for £in South Sea stock.
    • Government floating debt traded at a 32% discount prior to the announcement in May 1711.
    • The subscription closed December 1713 with South Sea shares at 94. Subscribers held at 38% capital gain.
    • The Sword Blade partnership bought government debt ahead of the announcement for a large discount.
  • Trading Operations
    • The Peach of Utrecht in March 1713 awarded England, and South Sea company with concessions to supply slaves to the Spanish American colonies:
      1. “The right to send each year a ‘permission’ ship of 500 tons to trade at the fairs either at Cartagena or Vera Cruz. The King of Spain was to receive 28.75 percent of the profits.
      2. Asientists were required to transport 4800 ‘piezas de Indias’ annually to Spanish America for 30 years (a ‘pieza’ was a negro with no defects at least 58 inches tall).
      3. Asientists were to pay 33 1/3 escudos on each of the first 4000 negroes and 800 entered duty free. The King of Spain was to share 10 percent of the profits.
      4. Payments for the negroes could be received in money, gold, silver bullion or ‘fruits of the country.’
      5. Slaves could be carried to all Spanish American ports.
      6. Unfortified ‘factories’ (trading centres) could be established to carry on the trade, staffed by up to six Englishmen per establishment.”
    • News of the award had little impact on the South Sea stock price.
    • The company lost money on the slave trade and only made just over £100,000 total from 1714 to 1718 shipping manufactured goods to Vera Cruz and Cartagena.
    • The trade ended in 1718 when war broke out with Spain.
  • Government interest payments to the company fell into arrears in 1715.
  • The company issued the second 1715 dividend in the form of bonds and both 1716 dividends in the form of stock.
  • 1719 Debt Conversion (Second Conversion)
    • Targeted £1.5 million in lottery loans in exchange for South Sea stock, plus £168,750 in stock to cover arrears to debt holders. Also, the company would lend £778,750 to the government funded through an additional share issue.
    • Only 70% subscribed, scaling down the conversion, arrears, and government loan by similar rate.
    • Debt holders got an 18% discount on their lottery loans for South Sea stock at par, but the market price of the stock traded within a range 112 to 117, and closed the year at 128. Subscribers sat at an immediate profit.
    • Everyone benefited — debt holders, government, and South Sea Company — because the company’s stock traded above par.
  • The English government saw John Law’s “success” with the Mississippi Company and conversion of French debt (France’s improved financial position) and a reason for further debt conversions of their own.
  • Blunt and John Aislabie (Chancellor of the Exchequer) proposed a massive debt conversion at the end of 1719. The Bank of England submitted its own proposal for the conversion. Bidding went back and forth.
  • February 2, 1720, the South Sea Company’s proposal was accepted by the House of Commons and got royal accent on April 7.
  • The 1720 Conversion Scheme:
    • The main parts of the approved scheme:
      • “The South Sea Company offered to buy in all outstanding long annuities, short annuities and redeemable debts, totalling approximately £31.5 million, in exchange for its own stock.
      • The Company agreed to pay £4 million unconditionally to the government plus a further conditional sum equivalent to 4.5 years’ purchase on all irredeemable debts exchanged by 1 March 1722, together with a penalty equivalent to one year’s purchase (up to £666,000) on all long annuities not exchanged by then, the maximum sum payable to the government under all headings being just under £7.6 million.
      • The government would credit the Company with an increase of £31.5 million both in its nominal capital and in the amount owed to it by the state if all the subscribable debts were exchanged. The basis on which debts were capitalised for this purpose was: 20 years’ purchase for the long annuities, 14 years for the short and par value for the redeemables.
      • The government agreed to pay interest on the increased debt partly at 5 percent and partly at 4 percent until midsummer 1727 when interest on all the debt owed to the Company would be reduced to 4 percent.
      • The government could start to pay off debts subscribed into the South Sea Company from midsummer 1727, that is, the entire debt had become redeemable.
      • The government agreed to lend the Company £1 million in Exchequer Bills as an immediate source of liquidity.”
    • “The real flaw in the 1720 refinancing arrangements concerns the payments the South Sea Company would have to make to the government. In order to be able to issue shares to make those payments, the Company would have to ensure that the conversion price of its stock was well above par. Yet there were no obvious means of generating sufficient profits to justify and sustain such a high share price.”
    • “…if the truth be, as I verily believe it is, that there is no real foundation for the present, much less for the further expected, high price of South Sea stock; and that the frenzy which now reigns, can be of no long continuance in so cool a climate; and amongst a people hitherto so justly famed for wisdom and prudence; I say, if this be the case, is it not the duty of the British Senate, to take all necessary precautions, to prevent the ruin of many thousands of families…” — Archibald Hutcheson, MP for Hastings, March 1720
    • Archibald Hutcheson, MP for Hastings, was one of the first to publish valuation analysis on the company and its proposals, starting in March 1720. His conclusions throughout the bubble were that the stock price was unrealistic due to a profit shortfall at the proposed conversion price. The company’s trading operation — which was losing money — needed to cover the profit difference to warrant, not only the current market price, but the conversion price. His valuation techniques relied on discounted cash flow, net assets per share, P/E ratios, and the sustainability of dividends (payout ratio and so on).
    • The South Sea Company published their version of the company’s “true” valuation before the debt conversion on April 9 at £448 per share, Hutcheson’s valuation put it at half that – £221per share. The market price at the time was over £300 per share.
    • “From the competition and opposition of the Bank may be justly dated the ruin of this scheme, and the rise of the miseries and misfortunes that have attended the execution of it…” — John Blunt, 1732
    • The South Sea Company had given “stock options” to Aislabie, other members of Parliament, and the King’s mistresses (possibly the King) to ensure support for its proposal. A total of £574,500 fictitious stock at a strike price of £200 was given out. The market price of South Sea stock was over £300 when the proposal was accepted in April.
    • Before the conversion scheme, Blunt took control of the company, set up an informal cabinet council, and made sure the governor and directors followed his lead.
    • Blunt borrowed the tactics of John Law to maximize the stock price during the conversion:
      • “by taking [the debts] in at different times, prices, and proportions, the proprietors thereof, (through apprehension of being either left entirely out, or coming in afterwards at a higher price) would be quickened to make their subscriptions, whereby the execution of the scheme would be rendered more easy and certain.” — John Blunt, 1732
      • Split the 1720 conversion scheme into 6 phases – 2 conversion offers and 4 subscriptions.
      • Allowed new shares to be bought with a low down payment and installments/subscriptions over several months (a public market existed for installment/subscription receipts).
      • The company purposely did not issue subscription receipts for the 3rd and 4th subscriptions in an effort to prevent them from selling the receipts in the public market.
      • The South Sea Company lent money to buyers of shares at 4%. Total money lent exceeded £11 million.
      • “Blunt, according to the Secret History, always insisted that the Company’s money should be lent, not to ‘traders and other such fair dealers’ but rather to ‘those who frequented the Alley and to Ladies and young Gentlemen, who came from the other end of Town [the West End], with a spirit of gaming’ since these ‘were the most likely to advance the price of the stock.’”
      • South Sea Company bought its own stock in Exchange Alley to prop up the price.
      • Used announcements of dividend raises to manipulate the price.
      • Conversion terms were priced at a premium to the going share price. Debt holders benefited by converting because it ensured a capital gain upon immediate sale, but he added a lock up period to prevent newly converted shareholders from immediately selling for a profit.
  • 1720 Timeline
    • February – Market price around £128 per share.
    • April – Market price around £300 per share (ranged from £280 to £340).
    • April 14 – First money subscription, £2.25 million stock at £300 (oversubscribed).
    • April 14 – Announced dividend raise to 10%, paid in stock.
    • April 21- Company directors agreed to lend £500,000 at 5%, with a max loan of £3,000 per person at a 30% margin, to those who wanted to buy South Sea shares. (almost £1 million was lent from April 21 to May 19).
    • April 28 – Registration of annuities for first conversion.
    • April 29 – Market price around £340.
    • April 29 -Second money subscription, £1.5 million stock at £400 (oversubscribed).
    • May 19 – Terms of exchange announced for first conversion, stock priced at 375 (the conversion price of the stock was not known by the public at the time of the announcement, yet 2/3s of debt holders agreed to convert).
    • May 20 – Market price around £400 per share.
    • May 29 – Market price around £500 per share.
    • May 31 – Market price around £600 per share.
    • June 2 – Market price passed £700 per share.
    • June 4 – Market price passed £800 per share.
    • June 11 – Archibald Hutcheson told the House of Commons he valued the company at no more than £200 per share and the dividend rate was unsustainable.
      • A market price of £1000 per share gave the company a £420 million market cap, greater than all the land in England at the time.
    • June 11 – Bubble Act received Royal approval, prohibiting any new company formations with Parliament’s approval.
      • South Sea directors believed the bubble in other stocks would hurt South Sea stock.
      • Enforcement was delayed two months.
    • June 17 – Third money subscription, £5 million stock at £1000 (installment payments allowed 10% down at 9 installments over 4.5 years, first installment payment due July 1721).
    • June – “When the rest of the world are mad we must imitate them in some measure.” — John Martin of Martin’s Bank (subscribed for £500).
    • June 22 – Company closes books to process midsummer dividend.
    • June 24 – Market price passes £1,000 per share.
    • July 14 – Registration of redeemable debts for second conversion.
    • July 14 – “”The managers of the South Sea Scheme appear to me to have copied exactly from the French Mississippi, in all the steps which have been taken.” – Archibald Hutcheson
    • Mid-July – Market price ranged from £980 to £1000.
    • End of July – Company waived the 3rd payment on the first subscription and 2nd payment on the second subscription and treated it as a loan to subscribers.
    • August 6 – Registration of redeemable debts and annuities for second conversion.
    • August 12 – Terms of exchange announced for second conversion, stock priced at £800.
    • Mid-August – Market price around £890.
    • August 17/18 – Enforcement of the Bubble Act on 4 companies — English Copper, Royal Lustreing, York Buildings, Welsh Copper — collapsed their stock.
      • The second order effect led to a minor crisis: the share price collapse in those stocks led to force selling due to margin loans, that spilled over to forced selling in other shares, defaults of goldsmith banks, a massive shift in sentiment, and flight to safety.
    • August 24 – Market price around £820.
    • August 24 – Fourth money subscription, £1.25 million stock at £1000 (oversubscribed).
    • End of August – Hutcheson valued the shares at £342. Market price around £775.
    • August – September – Company bought over £2 million worth of its own shares in the public market in an attempt to stabilize the price.
    • September 8 – General Court agreed to a 30% Christmas dividend and 50% annual dividend for next 12 months.
    • Mid-September – Market price around £520.
    • September 19 – Bank of England and government agree to bail out the South Sea Company due to its liquidity crisis.
    • October 1 – Market price around £290.
    • October 14 – Market price at £170.
    • November 9 – Bank of England backs out of the agreed upon bailout.
    • Mid-December – South Sea shares drop to £130.
    • “Tiz amazing that a company at first erected upon pretence of trade should take so little care to begin, fix, or improve any Trade, and that when at last they had got into their possession a great deal of ready money, they should employ their genius in stock-jobbing, or so to speak plain, in gaming away their own Treasure, and encouraging others in the same frenzy.” — Anonymous, 1720
  • It was rumored after the collapse that the South Sea company bribed stockjobbers to favor the interests of company’s stock.
  • The design of the conversion schemes and share subscription installments allowed for a self-fulfilling collapse.
    • Company loans to buy stock meant a drop in share price could lead to forced sales and further price declines (goldsmith banks also loaned millions to buy stock).
    • The risk existed of people not paying their subscription installments if the price dropped below subscription price and the company would lose that cash flow.
    • A falling share price makes it impossible to raise money through future share issues.
  • House of Commons established a “Committee of Secrecy” to investigate the company in January 1721.
    • The committee discovered the £574,000 of stock option bribes given members of Parliaments to pass pro-South Sea legislation.
    • The committee held corruption trials for those in the government that were involved in the scheme.
    • John Aislabie, Chancellor of the Exchequer and initial supporter of the scheme, became the primary scapegoat. He was only stripped of the gains from scheme amounting to £45,000.
    • “This unhappy affair, my lords, began at a time when the passion and avaricious desires of mankind were grown up to a madness and a distemper, and one cannot without pity look back upon the rage and folly of the year.” — John Aislabie,
  • Legislation enacted in January 1721 prevented South Sea directors from leaving the country, submit an inventory of their assets, and exclude them from holding directorships in the Bank of England, East India Company, and South Sea Company for life.
  • The Directors Bill was passed on July 29, 1721 outlining the confiscation of South Sea directors’ estates and any money they might keep. £2.3 million were confiscated.
  • On August 10, 1721, the Government unveiled the Act to Restore the Publick Credit that provided relief to the victims of the scheme:
    • “The £7 million owed by the South Sea Company to the government under the conversion scheme was excused, although the £1 million Exchequer Bills borrowed by the Company still had to be repaid.
    • Those who had borrowed from the Company on the security of South Sea shares or subscription receipts had to pay only 10 percent of the amount borrowed (it was later determined that brokers had to pay 20 percent). The pledged securities were forfeited.
    • Further calls on the money subscriptions were waived and subscribers were credited with stock valued at 300 (first subscription) and 400 (the other three subscriptions) in respect of cash already paid down.
    • The holders of government debt who subscribed in the second (August) conversion were credited with additional stock to equate their conversion terms with those of the first (May) conversion.
    • Any stock remaining in the Company’s hands was to be distributed rateably among all shareholders.
    • All contracts for the sale of company stock or scrip were to be invalid unless registered by 1 November 1721. All contracts for the sale of securities which the seller did not possess within six days of the bargain were to be void unless performed by Michaelmas 1721.”
    • In essence, the losers lost less with the relief.
    • Over 462 members of the House of Commons had subscribed to South Sea stock.
  • Bernard Act (1734) voided all option contracts and reaffirmed the short sale ban. It did not stop people from entering into such contracts.
  • “A study of the day-to-day relationship between South Sea stock and subscription receipts using co-integration analysis confirms…that there was no relationship between the daily prices of South Sea stock and the prices of the third and fourth subscriptions. Evidently there was a complete breakdown in the pricing mechanism that one would expect, within a rational framework, to establish a long-run equilibrium between these substitutable instruments.”
  • “Economic activity was largely unaffected: industrial output, so far as it can be measured, showed no discernible downturn; overseas trade dipped only very slightly in 1720–1721; and there is no reason to believe that agriculture, the largest sector of the economy, would have been impacted. The resolution of the crisis also ensured that there were no mass bankruptcies, although it is perhaps significant that, according to the bills of mortality, the number of suicides in London jumped by 40 percent in 1721.”
• Mississippi Bubble
  • John Law
    • Born in Edinburgh 1671.
    • Was convicted on murder charges from a duel with Edward Wilson in April 1694.
    • He fled to continental Europe, became a professional gambler, and built a net worth of over £100,000.
  • General Bank of Law and Company
    • Settled in Paris, befriended the Duc D’Orleans, and was given a charter for the General Bank of Law and Company in May 1716. It was capitalized with 825,000 livres.
    • “The key to the success of the General Bank lay in attracting deposits, against which it would issue its own notes, since deposits represented funding at zero interest cost.”
    • “Some 40 million livres of bank notes might be outstanding at any time, which would suggest a ratio of equity capital to deposits of around 2 percent and a ratio of capital to loans of 3–4 percent. The basic arithmetic of the situation was highly beneficial to Law and his fellow shareholders: the 825,000 livres of equity capital in the bank was supporting earning assets of perhaps 20–30 million livres, the gross return on which was, at an average interest charge of 5 percent, 1–1.5 million livres per annum before allowing for operating costs.”
    • December 1718, the Crown converted Law’s bank to a state-owned bank. Shareholders made an 800% profit, including dividends, over 2.5 years.
    • The new Royal Bank opened branches around France and scaled its operations.
  • Mississippi Company
    • Law tried to replicate the conversion scheme, and at a scale far beyond that, of the South Sea Company.
    • Law bought the defunct Mississippi Company, which held exclusive trading rights in French Louisiana.
    • “The Company that it is proposed to form, under the name of the Company of the West, has like the English South Sea Company, two objects—that of trade and that of retiring a considerable quantity of billets d’état and replacing them with shares, the credit of which it is hoped will be better sustained than those of the billets d’état.” — Ministry of Foreign Affairs
    • Law proposed an equal exchange of French government debt for Mississippi stock.
    • The new company launched in August 1717.
    • Law promoted the sale of land in the French Louisiana colony included exaggerated market on the abundance of gold, silver, copper, and “emeralds.”
    • 1718 it acquired the tobacco monopoly from the Crown for 2 million livres.
    • Took control of the trading activity of the Senegal Company at the end of 1718.
    • Acquired the Company of the Indies in May 1719, followed by the China Company, and Company of Africa — controlled the entire colonial trade of France.
    • Law issued shares to acquire the companies.
      • Shares were issued at 550 livres a huge premium to the market price, new shares could only be bought if you possessed four old shares, and purchases could be made in 20 monthly installments.
      • The market price rose to the price of the new offering in mid-June.
      • “An important factor in the buoyancy of Mississippi shares during this period was the rapid increase in money and credit that was occurring due to operations of the Royal Bank under the direction of Law… Law was actively using his control of the money supply to support his share flotations, fully realizing the close connection between liquidity and the behaviour of asset prices.”
    • Acquired the revenues of the Mint on July 20 — 6 million livres per annum for 50 million livres paid over 15 months.
    • Increased the dividend from 4% to 12% on July 26.
    • Announced a new share issue on July 27, to pay for the Mint.
      • Followed the same pattern as the previous offering. Shares were issued at 1,000 livres.
      • “The announcement of the issue terms was soon overtaken by events, a wave of investor enthusiasm carrying the shares to 3000 livres during the subscription period. According to one account,17 the Company responded by holding back some of the shares in a reserve fund and disposing of them in stages at even higher market prices.”
    • Law proposed paying off the entire outstanding debt of France into Mississippi shares at a cost of 5,000 per share done over three share issues from September to October 1719.
    • Price hit 5900 in September, 6500 in October, 6739 in November, and 10,025 in December.
    • Key Factors in the Price Rise:
      • Royal Bank note issues rose from 200 million livres in June to 1 billion livres by December.
      • Royal Bank offered better lending terms to Mississippi share purchasers at 2% up to 2500 livres per share deposited.
      • Rumors of a dividend raise based on profitability of trading operations.
    • Paris property prices soared during the same time as the shares.
    • Law was named Controller General of Finances on January 5, 1720.
    • Shares peaked on January 8, 1720 at 10,100 livres. The company held a 6 billion livres market cap.
    • January 9, 1720 the Company issued call options (called primes) on shares to dampen speculation in forward markets, but the options were underpriced which caused investors to dump shares for options. As share price fell, the option moved out-of-money and were worthless. Law converted 300 million livres of options to shares at a rate 10 options to 1 share.
    • On February 22, the Company’s share dealing office was closed and led to a 26% share price drop in one week.
    • “But our Mississippi here is no more than so many millions, with a fund of interest at four and five percent … and for no more continuance than seven years. Must it not be amazing, then, to see the madness of the people in being drawn into a stock, which has but seven years continuance, and which every man may see through.” — James Milner, April 1720
    • May 21 a decree was issued, and quickly revoked on May 28, imposing a gradual reduction in the value of Mississippi shares to 5,000 livres over 6 months due to inflation concerns. A similar devaluing of bank notes was imposed and revoked.
    • “It is in everyone’s mouth that they are robbed of half of what they were worth, that it is the most notorious cheat that ever was committed and that it is very plain now that Mr. Law has as little capacity as integrity.” — Daniel Pulteney, British Representative in Paris
    • Share price fell 17% from May 21 to May 27, and another 44% from May 28 to May 31 as outrage grew and confidence waned.
    • Law was dismissed on May 29, then recalled on June 2 (to take the blame if things got worse), but he was no longer in full control.
    • Mississippi shares were devalued to 2000 livres in September.
    • The Mint and other sources of tax revenue were taken from the company.
    • Royal Bank closed on November 27.
    • December 8, trading in Mississippi shares were prohibited.
    • John Law fled France on December 17. His land was confiscated. He settled in Venice until his death on March 21, 1729.
  • “The loss of financial confidence was not fully reflected in the Mississippi share price which declined by approximately two-thirds from peak to trough. After all, French investors in the summer of 1720 were faced with an unenviable choice between the market risk of Mississippi shares, the convertibility risk of bank notes and the regulatory risk (devaluations, restrictions on use, etc.) associated with specie.”
  • The bursting of the Mississippi Bubble led to comparisons on the future of South Sea stock.
• 1720 Broader Market Bubble
  • “During the period 1 January to 22 June 1720, when the South Sea books were closed, the share prices of other leading companies also soared with the Royal African Company, in particular, registering an increase similar to that of South Sea shares.”
  • Royal African Company shares rose 483%, Bank of England shares rose 60%, Million Bank shares rose 246%, Easte India Company shares rose 70%.
  • New companies “IPOs” exploded during the year. Most new companies were finance or insurance related but others ranged from practical to absurd.
  • Over 200 companies were created, of which only 4 survived.
  • “The common characteristic of these lesser bubbles was that they typically involved big headline capital sums of £1 million, £2 million or more, designed to convey the importance and potential scale of the enterprise, while requiring only very small initial contributions from investors.”
  • The installments allowed for a low buying price equivalent to 0.125 to 1 percent of the IPO price.
  • Installment receipts for new companies traded in Exchange Alley, were highly volatile, and showed gains ranging from 20 to 35 times original price at its peak.
  • By mid-summer, the total market value of new companies was estimated to be around £300 million.
  • “Yet many of those very subscribers were far from believing these projects feasible: it was enough for their purpose that there would very soon be a premium on the receipts for those subscriptions, when they generally got rid of them in the crowded Alley to others more credulous than themselves. The first purchasers of these receipts soon found second purchasers, and so on, at still higher prices coming from all parts of the town.” — Anderson, 1764
  • “I had a fancy to go and take a look at the throngs…and this is how it struck me yesterday: it is like nothing so much as if all the lunatics had escaped out of the madhouse at once.” — London attorney of a Dutch investor
  • “Trade has completely slowed down, that more than one hundred ships moored along the river Thames are for sale, and that the owners of capital prefer to speculate on shares than to work at their normal business.” — reported from the Hague
  • The bubble extended outside England, across Europe:
    • France experienced it with the Mississippi Bubble.
    • 40 new companies were advertised in the Netherlands.
    • Hamburg dealt with insurance company proposals.
    • Lisbon saw “the Brasil Bubble.”
    • The collapse of the bubbles in Paris and London also spilled over to other European markets.
    • It was the first international bubble and crash.
• “Our market system depends critically on trust—trust in the word of our colleagues and trust in the word of those with whom we do business. Falsification and fraud are highly destructive of free market capitalism and, more broadly, to the underpinning of our society.” — Alan Greenspan 2002
• “There is something else going on here, though, which is a fascinating thing to watch. It is, for want of a better term, the ‘lottery principle’. What lottery managers have known for centuries is that you could get somebody to pay for a one-in-a-million shot more than the value of that chance. In other words people pay more for a claim on a very big pay-off, and that’s where the profits from lotteries have always come from. So there is a lottery premium built into the prices of internet stocks.” — Alan Greenspan, on the Dotcom Bubble 2002

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