FINANCIAL CRISES PAST & PRESENT
John Munro, University of Toronto
The South Sea Bubble of 1720 and its
relationship to the current financial
crisis: an old and still current story of
greed, fraud, and stupidity
LEVERAGE AND LIQUIDITY
• From: UBC Faculty Pension Plan: Pension
News, Third Quarter 2008 Edition
• Two concepts are important in understanding
the events of the past year:
• leverage and liquidity:
The UBC Pension Plan News: Leverage
& Liquidity
• LEVERAGE is the use of borrowed funds to purchase
assets greater in value than the initial amount of
equity.
• A common use of leverage is by individual
homeowners who might purchase a $500,000 home
with $100,000 of equity and $400,000 of borrowed
money. The leverage magnifies the rate of return: so, if
for instance the value of the home increased by 20% to
$600,000, the homeowner’s equity increased by 100%
to $200,000.
Leverage & Liquidity
• LIQUIDITY is the ability to access cash, investments or credit
to finance transactions by individuals, businesses and
governments.
• If credit is not available, the ability to transact business
becomes more difficult. As the financial soundness of
individuals, companies (especially financial institutions) and
even governments is questioned, vendors and lenders
become increasingly reluctant to transact business because of
the uncertainty of being paid.
• Business slows down, and companies that need credit to
operate, but find it inaccessible, can fail.
More Current Views:
William Robson, CD Howe
• Forced Liquidations and the Financial Crises
• ‘Forced liquidations – urgent cash needs that
make people unwind arrangements that they
would rather leave in place – are a principal
cause of the current financial crisis. Savers sell
at a loss and financial institutions face sudden
demands for liquidity, which suddenly
becomes scarce.’
THE SOUTH SEA BUBBLE of 1720: Origins of joint stock
companies
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1553: formation of the Muscovy (Russia) Company
England’s first joint-stock company (probably also the first in Europe)
Capital raised by the sale of shares of ownership: jointly held stock
England’s first long-distance overseas trading company
a chartered incorporated joint-stock company: with a monopoly on Russian
trade
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1600: Incorporation of the East India Company: with a monopoly
charter on Asian trade
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1694: Incorporation of the Bank of England: also a joint-stock company
with a dual monopoly: on government banking and joint-stock banking
in return for a permanent loan of £1.2 million at 8% (6% from 1709, 3% from
1742)
initial stage of the Permanent Funded National Debt (with 1693 Million Pound
Loan)
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The South Sea Bubble: Origins
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Note: a secondary market for trading in (buying and selling) previously issued
shares
by this time, England had 137 joint-stock companies, most of which were
unincorporated.
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1695: formation of the London Stock Exchange (LSE): on Lombard Street
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thus, it broke the original East India Company’s monopoly on Asian trade.
in return for a permanent loan of £2.0 million at 8%: also part of the national debt
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original East India Co forced the New East India Co to amalgamate (a ‘take-over’)
in return, for another permanent government loan of £1.20 million at 6%
1698: New East India Company Incorporated:
1709: Incorporation of the United East India Company
The South Sea Project: to take over
the national debt
• 7. 1711: Establishment of the South Sea Company: third
of the Three Sisters
– .chartered, incorporated joint stock company with a monopoly
on South Pacific trade (lucrative Mexico-Philippines-China
trade, controlled by Spain)
– .real objective: to take over all the outstanding national debt not
held by the Bank of England and the East India Company
– .converted six series of English short debt, worth £9.471 million
– paying interest annually at 6.25% to 9.0% – into 5%
perpetual stock of the South Sea Company
– .WHY? Why would recipients find this conversion beneficial?
– .beginning of a nine-year stock market boom on the LSE
The South Sea Co Project: to take over
the National Debt
• 8. 1719-1720: South Sea Company attempts to convert
the remainder of the outstanding national debt (not held
by the Bank of England, East India, and South Sea Cos.)
– .the total proposed conversion was £31,580,888 = 64.18% of the
national debt
– .remaining £18,321,872 = 26.72%: already held by the Three
Sisters
– .takeover to be financed by a new IPO: Initial Public Offering
(not on the LSE)
– .but the proposed conversion terms stipulated that the
outstanding issues of government debt, at par value, were to be
converted into South Sea Co stock at prevailing market prices on
the London Stock Exchange
The South Sea Bubble begins
– .South Sea Co. employees operated a ‘boiler room’ to drive up
stock prices: for, the higher the market price of the shares, the
fewer shares would be surrendered
– .hence the beginning of the ‘bubble’, which spread to other
stocks
– .virtually everyone had always bought shares on 10% margin:
borrowing the rest from their brokers as demand ‘call loans’, but
pledging all assets as collateral
– If a buyer paid £10 for £100 share, and value rose to £120,
buyer made a 200% gain: i.e., a £20 gain on his £10 investment.
– Hence the ‘leverage’
– .with the Bubble mania, most who bought shares did so in the
hope of quickly reselling them at higher prices, i.e., for capital
gains, not for the 5% dividends
The 1720 Bubble Act: the Bubble is
Pricked
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9.
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.South Sea Company requested (and paid for) the act: to limit the activities of other
financiers and speculators who were similarly raising capital by selling new IP0s
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.Act restricted the right of marketing shares, on the London Stock Exchange, from 24
June 1720: to just those companies possessing a legal charter of incorporation
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.The statute also required those companies to operate solely within their charter
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.Most joint stock companies lacked charters of incorporation: i.e., those held by the
Three Sisters and a very few other companies (e.g., The Hudsons’ Bay Company)
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August 1720: South Sea Co. launched a legal suit against three insurance companies for
violating the terms of their charters:
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The Bubble Act of 1720: statute 6 George I cap. 18,
and thereby committed financial suicide
The Bubble Crisis and the1720 Stock
Market Crash
• 10. The Bubble Crisis and Stock Market Crash:
August - December 1720
• .Result: PANIC! stock prices for the threatened
companies plummeted
• - York Buildings Insurance: fell from £305 to £30
• - London Assurance: fell from £175 to £30
• - Royal Exchange Assurance: fell from £250 to £60
1720 Stock Market Crash: Reasons
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Financial climate of pessimism and widespread fear not the only reason
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Major Financial Reason: once prices fell, brokers who held stock as collateral for
‘call loans’ immediately sold the stocks and demanded that buyer-borrowers pay
up
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Those required to redeem their call loans were forced to liquidate their assets,
beginning with their good stocks (e.g., those of the Three Sisters, Royal African)
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Prices of other ‘good’ stocks began to fall sharply: Gresham’s Law of Finances
[Gresham’s Law: bad money drives out good money]
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Obviously South Sea shares fell the most: as the most inflated
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hence a system based on LEVERAGE (margin) led to a LIQUIDITY CRISIS
Consequences: 1720 - 1825
• 11. The Consequences were many and manifold:
• above all, Parliament used the ‘Bubble Act’ to prevent the formation of
joint-stock companies (except for canals in 1780s) to 1825.
• Industrial Revolution (1760 – 1820): new industries had to find
alternative methods for capital financing
• Chiefly for fixed capital: mortgages and private loans
• For working capital : discounting & short term lending from the new
‘Country Banks’
• Without joint-stock and branch banking, as the Scots enjoyed, hundreds
of English banks failed: 93 alone (out of 715) in 1824
• Hence: abolition of the Bubble Act in 1825 & repeal of Bank of England’s
monopoly in 1826
The South Sea Bubble: Graphics
Dilbert on the Current Crisis
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Governments Debts Exchanged for 5% South Sea Company Stock in 1711 in pound sterling
Category
Type of Debt
Amount
1a
1b
1c
Navy and Victualling to Michaelmas 1710
Ordnance to Michaelmas 1710
Transport office to Michaelmas 1710
Subtotal
5,130,539
154,325
424,791
2a
2a
2b
2c
3a
3b
4
Army and Transport debentures up to 1702
accrued interest on these debentures to 1710
Shortfall in coal duties to pay loans: 1697, 1702
arrears in subsidy to Elector of Hanover
Subtotal
Navy, Ordnance, Transport Debts 1710 378,859
Interest of debts for 1710-1711
85,000
Subtotal
Percent
5,709,655
60.28%
1,040,057
10.98%
463,859
4.90%
1,371,428
14.48%
987,157
31,500
12,025
9,375
Principal and interest on short-term loans 1710-11
5
Sum for current supply
500,000
5.28%
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Interest on whole debt for 1711
386,325
4.08%
9,471,324
100.00%
TOTAL
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Structure of British Government Long-Term Debt in 1719
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in pounds sterling (current values)
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Category of Debt
1
Debt Owed to the ‘Three Sisters’ (Corporations)
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1a
1b
1c
Bank of England
East India
South Sea
sub-total
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Redeemable Government Stock
3
Annuities
3a
99 year annuities
(@ 20 yrs purchase)
26.71%
2&3
TOTAL
3,375,028
3,200,000
11,746,844
Company
Company
2
3b
Totals
32 year annuities
6.76%
6.41%
23.54%
18,321,872
16,546,202
121,669
666,566
5.000%
7.143%
1,703,366
36.72%
33.16%
13,331,320
3.41%
subtotal: annuities
15,034,686
30.13%
Sub-total: gov’t stock & annuities
31,580,888
64.18%
49,902,760
Percent
100.00%