South Sea Bubble is the story of greed and avarice and a mad crowd that took the South Sea Company stock to a dizzying height. Then it crashed a hurt many many people. Many people lost their fortunes and some made their fortunes as well. It happened some 300 years back but it is still relevant today. The same thing has been been repeated again and again. Whatever happened then has been repeated with variations of course but the basic crux is the same. The last time that it caused so much pain and anguish was the 2008 financial crash which almost crashed the financial system of US. Why this bubble formation and then market crash happens over and over again? The main reason is we are emotional creatures and we don’t learn from our mistakes. Again and again we get blind sided by greed and take took much risk.
I got interested in the South Sea Bubble when I learned that the famous Isaac Newton who invented calculus and revolutionized the world of physics with this theory of gravity that explained how the planets and comets moved in the universe lost something like £20K investing in the South Sea Company shares. In today’s money this £20K is something close to $40 million. So it was a huge amount and Issac Newton was greatly distressed on his folly but thank god he didn’t commit suicide. He could solve the equations but he was a poor investor. This is what we can say or was he that poor as an investor? We will see in this post. Then we have East India Company a shameful chapter in British history. They still call it there empire. Was it there empire or was it a loot and plunder of poor people on a massive scale. You should also not forget the massive role Britain played in the kidnapping and enslavement of millions African people and how this free labor was very important in the early phases of capitalism. Today if you see BBC documentaries they simply try to whitewash these atrocities. Last but not the least don’t forget the opium trade. British people have committed massive crimes in history.
British Wars result in massive government debt
Let’s start. In the 17th century, British society saw a lot of tumult. In 1640s a bloody civil war took place and end with the beheading of the king heralding the trump of democracy over autocracy. From them on parliament was the supreme institution in Britain. In the late 1680s Britain had the Glorious Revolution. William became the king. There were wars that Britain had to fight. Of course you need money a lot of money to fight a war. You have to arm and feed an army for many months. How do you finance a war?
Silver Coin Smuggling Problem
Let’s start the story. I will give rough details and make things very simple and easy for you. I will give rough figures so don’t worry to much about them. In the 17th century, Britain had silver coins. There was a perpetual shortage of silver coins in the country. Why? Silver price was higher in Paris and Amsterdam. So smugglers had a profitable business melting the silver coins and smuggling the silver to France and Holland and selling it there and then returning and buying more silver coins as silver coin price was cheaper in Britain. This is a good example of arbitrage. Now a days things are lightening fast and arbitrage opportunity is very rare and fleeting. But then this arbitrage opportunity was there for many years and smugglers exploited it to the fullest.
Sir Isaac Newton becomes Master of Mint
Now enters Sir Isaac Newton. He had been a professor at Cambridge for 30 years. But somehow he developed friendship in higher places and got appointed as the Warden of Mint and after a few years as Master of Mint. It was the job of the mint to make these silver coins. It is reported in history books that Newton got the job at Mint by offering his young very beautiful niece Catherine Barton as a mistress to Charles Montagu Earl of Halifax and Chancellor of the Exchequer. Newton made the working of the mint more professional. But the problem of perpetual shortage of silver coins in the country was hurting business transactions and the economy a lot. When asked his opinion, he proposed to reduce the weight of silver in the coin. According to him, value of money is just a matter of opinion. By reducing silver weight in the coin, smugglers will find it not profitable to melt silver coins and smuggle silver. His opinion was heard but parliament decided to keep the weight as it was as it would have hurt the British integrity. So whatever new coins were being minted were being hoarded and old silver coins were getting melted. This is the background of Gresham’s Law.
Bank of England gets created
This problem got solved with the creation of Bank of England in 1690s. Bank of England issued paper money for the first time with the promise to exchange it for a certain weight of silver or gold. So now paper money started circulating in the British economy for the first time. Bank of England was a join stock company that had floated its own shares. There was a board of directors and it extended millions of pound loan to the government.
Britain was engaged in empire building a shameful chapter. More on the shameful things British did in making their empire and then its sudden sad end. I will write a blog post on that how Britain looted and plundered the poor people in the world and started the slave trade. France was also engaging in empire building so both Britain and France had a number of wars that were costly. Britain financed its wars by selling lottery tickets which were in fact like modern day bonds. One famous lottery was Million Adventure lottery. Britain also sold annuities to the public with the promise to pay a fixed amount till death. Exchange Alley was the street where most of these transactions used to take place. Now the problem was Britain raised all this money at a high rate of interest from the public something like 7-9%.
South Sea Company Act gets passed
In 1700s when the new century starts British treasury is facing a lot of problems raising new finances and servicing the old finances. Something needs to be done. Enters John Blunt a sharp and cunning man with a brand new scheme. I am making thing simple. He proposes a new company South Sea Company that would take the British government debt and in place issued shares to the holders of the annuities and the lottery tickets and stuff like that and reduce the interest being charged to the British government and make it less than 4%. So in nutshell South Sea Company will be issuing shares that would be backed by the government debt and of course trade. South Sea Company will trade with Spanish colonies in South America. Main items will be African slaves and stuff like that. So you see Britain was fully involved in this slave trade and got rich on the back of the poor African men and women who got kidnapped and later would toil all day in America. War started with Spain and prospect of trade with Spanish colonies diminished. John Blunt was a cunning man. He bribed many members of the British Parliament and got the South Sea Company Act passed in 1711. South Sea Company will solve British government debt problem. £100 share were issued. Annuities holders and lottery ticket holders were offered these £100 shares and the dividend income that will accrue from trade. The trick lies in increasing the share price above £100 by rumors and other clever tricks. As long as people buy the shares, its price will increase. So for the first time margin trading was allowed. You don’t need to invest the whole amount. People could invest 25-50% of this amount and pay the rest in installments.
South Sea Bubble
In 1720 the bullish run starts. South Sea Company share starts from £100 then rises to £200 then £300 then £500 then £800 then £1000. People are going mad. All this price rise is manipulated by John Blunt and his cohorts. A Ponzi scheme had been created and became known in history as South Sea Bubble. This Ponzi scheme can only prosper as long as money keeps flowing in. John Blunt knows this. He and his cohorts need manipulation and tricks to fool the people and make the money flow into the South Sea Company shares. This they do. This was the first time options contract and the forward contracts also got introduced. People started punting buying options contracts and forwards contract. For the first time trading on margin is allowed. In those days it took time to record the sale and purchase of shares in the registers. This also allowed John Blunt to suspend trading in South Sea Company shares for period of two months. So he had many tricks that he used to prop up the share price. Just imagine the share price started from £100 and went up to £1000 in a matter of months in one year 1720. This shows how cunning John Blunt was.
Was there no one who could see that this is a bubble and the share prices will collapse soon? There were a few people who tried to warn the general public that this was all a scam and the share prices were not reflecting the fundamentals. South Sea Company business of trade was not working. One such person was Archibald Hutcheson. He for the first time tried to calculate mathematically the true price of the South Sea Company share price. He used a number of scenarios. In those days, modern finance has not been born yet. Concept of paper money, return, stock price were hazy and not clear. It was not clear how to calculate the future income of a stock. But this man had some concepts that are pretty close to how we think now a days. He showed that £500 price was too high and the South Sea Company fundamentals only warranted a price of £180. People were paying too high a price for the South Sea Company shares. He published pamphlets in which he explained his reasoning that the South Sea Company share price was not more than £200 when people were paying £800-£1000 for it.
Sir Isaac Newton loses $40 million in South Sea Bubble
John Blunt got knighted and became Sir John Blunt afterall he had solved the problem of massive government debt. Enter Sir Isaac Newton. He had bought annuities over the years. So he converted them to South Sea Company shares when the share price was £200. He sold at £300 and took profit and made £20K profit a huge amount in those day on investment of £10K. He doubled his investment and then he was out of the market. He should have avoided the temptation to enter the market again. But when South Sea Company share price reached £800 he became edgy again and bought South Sea Company shares at £800 with all the money he had. He was dreaming to sell wwhen South Sea Company shares reach £1500-£2000. Then all of a sudden with 2-3 weeks everything collapsed and South Sea Company shares collapsed below £150. Issac Newton lost something like $40 million in today’s money. He was flabbergasted and disheveled. Newton was the greatest mathematician of his times and perhaps one of the greatest of all times. But investing and stock trading was beyond him. He had been working successfully as Master of the Mint. He had given opinion on economic matters to Parliament which seems to be sound and solid by modern standards but I thing he was carried away by his emotions. This is a sin that most of us commit as traders and investors. He invested a lot of money at the wrong time when the share price has almost topped without proper risk management and paid the price. He is not the only person making this mistake. This mistake is made again and again. Even today this is one of the most common investing mistake.
But not everyone was Newton. John Guy was a book publisher. He was a self made made. He made his fortune selling Oxford Bible. He bought 50,000 South Sea Company shares at a price of £50K so the average price comes out to be £100 . His entry price is very good. He bought at the price at which the shares were issued. He started taking profit slowing when the share price reached £300 and sold the last shares when the share price was £700. After that he was done and never thought of reentering the market. His total profit was something like £400 million in today’s money. He did philanthropy with this money and made a hospital that still stands today. Lady Sarah wife of Duke of Marlborough was an astute investor. She sold all her shares when price reached £500. After that she never thought of entering the market again. Newton made profit first time but then he reentered the market again when the bubble was about to bust and got clobbered. Always keep this in mind when you miss the train don’t try to chase it. In the Internet Bubble people got clobbered when they tried to buy internet stocks at the top. The story of South Sea Company bubble then got repeated in 2008 when Lehman Brothers took heavily leveraged positions and when price fell got busted. Mortgage backed securities were almost similar to the South Sea Company shares. You see history keeps on repeating and we never learn from history.
South Sea Bubble Aftermath
There was a huge hue and cry thousands of people had lost their fortunes in the South Sea Company Bubble. The government credit market was in shambles. People demanded their money back. Parliament opened an inquiry. South Sea Company accountant who had the list of members of Parliament who had taken bribes from South Sea Company first refused to reveal the names to Parliament committee and when got the chance escaped in a boat to Europe with his son. Sir John Blunt bought a lot of land in 1720 from the profit of South Sea Company shares that he sold. This amount was £200K and more a huge amount in today’s money. Robert Walpole was given the charge of solving the South Sea Company debacle. He proposed to break the company into three small companies. The conversion of government debt into company shares would not get reversed. But people would get some compensation. He confiscated John Blunt assets and assets of other culprits in the scam and the money was used to reimburse the losses to the investors. A few powerful people committed suicide when they feared being exposed infront of the people. Formation of new joint stock company was got banned. Ultimately investors got something like half of their losses reimbursed. Robert Walpole made his reputation and became the Britain Prime Minister.
The mechanism is the same. Greed and avarice makes people blind. This is also known as the madness of the crowd. This got reflected in the Tulip Mania a century before in Holland and again and again. Greed was the main cause of 1929 stock market crash. People thought price will keep on going up never reflecting that what goes up also comes down. People invested heavily on margin in the stock market and got their shirts burned. Then in 2008 again we see it happened. So all financial bubbles are almost similar and no lesson is learned. Why? We are all emotional creatures and when emotions take over we ignore logic and reason.