From the Federal Reserve Bank of New York's Liberty Street Economics blog:
In 1720, the South Sea Company offered to pay the British government for the right to buy the national debt from debtholders in exchange for shares backed by dividends to be paid from the company’s debt holdings and South Sea trade profits. The Bank of England countered the proposal and the two then competed for the right to buy the debt, with South Sea ultimately winning through bribes to the government. Later that year, the government moved to divert more capital to South Sea shares by hampering investment opportunities for rival companies in what became known as the Bubble Act, and public confidence was shaken. In this edition of the Crisis Chronicles, we explore the rise and fall of the South Sea Company and offer a cautionary look at the current reach for yield.
A Rogue’s Guide to Repackaging Debt: Start with Insider Trading . . .
Two key events predate the South Sea Bubble. First, around 1710, the Sword Blade Bank offered to exchange unsecured government debt issued by army paymasters for Sword Blade shares. But it did so only after having secretly amassed large holdings of the debt, which traded at a deep discount given investor uncertainty that Britain could pay its debts. Knowing the price of the debt would rise with the announcement of the debt-to-shares exchange, the Sword Blade Bank made a significant profit on its debt holdings in what would today be called insider trading.
The second key event was the formation of the South Sea Company in 1711, for the purpose of rivaling the East India Company in trade. But a unique feature included in the formation of the company was the exchange of shares for government debt, no doubt influenced by the prior Sword Blade Bank deal; five of the directors of the South Sea Company were from the Sword Blade Bank. By 1713, the peace treaty at Utrecht brought an end to war with Spain, but the British gained only limited access to trading stations in the Americas. Consequently, the trading operations never proved profitable and the South Sea Company became a financial enterprise by default. In 1715, and then again in 1719, the South Sea Company was allowed to convert additional government debt into shares. In April 1720, South Sea won approval to buy the remaining government debt and to issue stock in exchange. The once-burdensome debt had been cleverly repackaged into a valuable commodity.
Then Pay Bribes . . .HT: The Big Picture
Investors in South Sea shares now anticipated both a 5 percent annual dividend payment in addition to the hope of lucrative profits from trade with the Americas. But on the announcement of approval to buy the remaining government debt on April 7, 1720, the South Sea share price fell from £310 to £290 overnight.
South Sea directors were eager to pump up the stock price and spread rumors of even greater riches to be earned from South Sea trade. Later that month, South Sea offered to new investors its First Money Subscription of £2 million in stock at £300 a share with 20 percent down and the remaining payments to be made every two months. So successful was the first offer that a Second Money Subscription followed later that same April with equally generous terms that allowed participants to borrow up to £3,000 each. Nearly 200 new ventures were launched that year under similar schemes, increasing the competition for investor capital. In the short term, shares soared across most companies. But South Sea stock sale proceeds were needed to pay dividends and bribes to the government for favorable treatment, as well as to buy its own shares to support its stock price. Consequently, a Third Money Subscription was launched later that year with even more generous terms at just 10 percent down with installment payments over four years and the second payment not due for a year....MORE
Previously:
Prop Trading the South Sea Bubble: Hoare's Bank 1720
"How the South Sea Bubble Created U.K.'s Modern Monarchy"This paper presents a case study of a well-informed investor in the South Sea bubble. We argue that Hoare’s Bank, a fledgling West End London bank, knew that a bubble was in progress and nonetheless invested in the stock: it was profitable to “ride the bubble.” Using a unique dataset on daily trades, we show that this sophisticated investor was not constrained by such institutional factors as restrictions on short sales or agency problems
Murphy A. (2009) The smartest boys in the alley, early derivatives on the London stock market
Not your standard 'bubble fare', eh?
