Crisis Chronicles: The South Sea Bubble of 1720—Repackaging Debt and the Current Reach for Yield

James Narron and David Skeie

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 . . .

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.

. . . And Ban Rivals
Later that summer, the government moved to ban the new ventures—South Sea’s rivals for investor capital—in passing the “so-called” Bubble Act, which jolted public confidence. Companies
impacted by the ban saw their stock prices plummet and leveraged investors were
forced to sell South Sea shares to pay off debts, which put downward pressure
on South Sea’s stock price as well. To prop up the company, South Sea launched
the Fourth Money Subscription in August with a promise of a 30 percent year-end
dividend and an annual dividend of 50 percent for ten years. But the market
didn’t view the offer as credible and the South Sea share price continued to
fall through mid-September. Liquidity constraints in London were further
compounded by the concurrent Mississippi Bubble and bust in Paris, which we’ll
cover in our next post. The South Sea Company was forced to turn to the Bank of
England for help with the Bank ultimately agreeing to support the company but
not its banker, the Sword Blade Bank.

    
Recall from our last post
on the “not so great” re-coinage of 1696 that after the re-coinage, silver
continued to flow out of Britain to Amsterdam, where bankers and merchants
exchanged the silver coin in the commodity markets, issuing promissory notes in
return. The promissory notes in effect served as a form of paper currency and
paved the way for banknotes to circulate widely in Britain. So when panicked
depositors flocked to exchange banknotes for gold coin from the Sword Blade Bank
(the South Sea Company’s bank), the bank was unable to meet demand and closed
its doors on September 24. The panic turned to contagion and spread to other
banks, many of which also failed.

The Return of Repackaged Debt
As we’ll see in upcoming posts, financial innovation—in this case the repackaging
of debt—is a recurring theme in our review of historic crises. In this case,
the South Sea Company structured the national debt in a way that was initially
attractive to investors, but the scheme to finance the debt-for-equity swap
ultimately proved to be noncredible and the market collapsed. Now fast-forward
to 2013 and the five-year anniversary in September of Lehman Brothers’ failure.
As Fed Governor Jeremy Stein pointed out in a recent speech,
a combination of factors such as financial innovation, regulation, and a change
in the economic environment, can sometimes contribute to an overheating of
credit markets. Asset-backed securitization and collateralized debt obligations
have returned with a bang—or perhaps a boom—and are on pace to exceed pre-crisis
levels, perhaps fueled by investors’ reach for yield. And remember from our introduction
to the Crisis Chronicles series that “lessons learned often last only a
lifetime and are easily forgotten.” So, will the current reach for yield lead
to ever more complex, leveraged investments and the next credit market bubble?
Or will the lessons from the Great Recession last at least a lifetime? Tell us
what you think.

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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James Narron is a senior vice president in the Federal Reserve Bank of New York’s Executive Office.

David Skeie is a senior economist in the Bank’s Research and Statistics Group.