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The South Sea Bubble

The South Sea Bubble

The South Sea Bubble occurred in 1720, and it centred on the South Sea Company that was formed in 1711 as a public-private partnership to manage and consolidate British debt. The company earned exclusive rights to supply African slaves to the ‘South Seas’ region, which is now Central and South America. This deal promised to be very lucrative and money-spinning, attracting all rungs of society to seek a slice of the cake. By August 1720, share prices of the company hit highs of above £1,000, but just a month later, in September 1720, the bubble burst, and prices tumbled to lows of below £150. The stock prices never recovered above that level until the company was abolished much later in 1858. More than 300 years later, the South Sea Bubble remains a byword of financial crises, a symbol of crowd greed as well as insider trading. But what actually happened?

The Background

Fighting wars on two fronts (the War of Spanish Succession and the Great Northern War), the UK government had seen its finances stretched to the limits. A series of innovative solutions, such as running lucrative national lotteries, were attempted while every debt owed by the government was taken stock of and consolidated. The South Seas Company was then formed in 1711, and all debt holders would receive an equivalent amount in shareholding. The government surrendered all debt to the company (amounting to about £9.5 million) with a guaranteed interest payment of 6% annually that would be distributed to debt holders who would now be shareholders of the company. Despite the high amount, this was an attractive deal for all parties involved. The South Seas Company had secured exclusive rights to trade with Spanish South America, but this was to commence after the prevailing war ended. The government felt that the 6% interest it was supposed to pay every year could simply be recouped by taxation of goods brought from the trade. While debt holders who had been doubting the capability of the government to meet their obligation, they now felt a lot safer as shareholders of a promising company.

Not so Lucrative Deal

In 1713, the Treaty of Utrecht that effectively ended the war with Spain was signed. Britain opened offices in selected locations across South America and was permitted to deliver one ship of no more than 500 tons to any of those places once a year. What seemed initially a money-spinning deal now proved not so great. Slaves delivered to South America did not command reasonable prices, and in some cases, goods on the return journey did not garner much market demand. Despite this, King George I became the governor of the company in 1718, helped by other prominent politicians and leaders as directors. This created some confidence in a company whose future prospects heavily depended on the goodwill and favour of the government.

Fundamentally, the South Sea Company had no positive business prospects as another confrontation with Spain erupted that same year. But the company was very confident that its long-term growth potential was immense.

The Start of the Bubble

The fortunes of the company, however, changed in 1720 when the company presented a scheme before Parliament to take over the national debt. The Bank of England was unable to present a better offer, and the South Sea Company was now a ‘rejuvenated’ company whose trade prospects were set to be enhanced in the ‘New World’. It was also expected that value would be created by the growth of its share prices.

The national debt adoption plan was implemented in April 1720, but the excitement had been building around the stock of the South Sea Company from the time it was first proposed in January 1720. The share price of the company had started that year at around £128, but by May 1720, it printed highs of circa £550. Investors had completely disregarded the fact that dividends scheduled for December 1719 had been postponed for one year, and the company’s stock price was based on future prospects rather than prevailing business realities.

Bubble Acceleration and Burst

Along the way, the South Sea Company offered politicians and heads of government shares in the company. This helped to align their interests with that of the company. On its part, the South Sea Company published its elite shareholders to further add to the appeal and legitimacy of their shares. At this time, there had emerged several other companies that were also making weird claims about foreign voyages as well as schemes, such as shipping insurance. Some companies were outright frauds, while others had no legal basis. They were collectively branded as ‘bubbles’ and had caught the attention of the House of Commons. In June 1720, the ‘Bubble Act’ was passed after a committee recommendation. Ironically, the South Sea Company was one of the supporters of the Act, which stipulated that only an Act of Parliament could incorporate a joint-stock company – one that can raise capital from the public.

The passage of this Act helped to prop up the South Sea Stock to highs of £890 in June 1720. This prompted some shareholders to engage in profit-taking. But the company took measures to prevent a selloff by encouraging their agents to buy the stock. The stock managed to rise to £750, and it seemed it was destined for the moon. Herd mentality gripped the market, and people scrambled for the South Sea Stock that promised legitimate wealth within a short period of time. The South Sea Company stock experienced demand from all types of people – from lords to peasants – and it finally reached £1,000 in August 1720. A psychological price level had been reached, and there was heavy selling such that by the end of September 1720, the stock traded at £150. By the end of 1720, the stock had fallen to £100.

The Impact of the South Sea Bubble

The South Sea Bubble impacted British society deeply and extensively. Earlier, when the company wanted its stock to appreciate, it handed out loans to people to buy the stock. Numerous other banks and goldsmiths also dished out loans based on the stock of the South Sea Company. Many individuals had no way to pay back the loans apart from selling the stock. Many households were wrecked, and lenders could not pay the loans made on the stock. The impact was so huge that it is reported that renowned physicist Sir Isaac Newton was an investor in the company and he lost an estimated £2.4 million (in today’s money). The outrage was nationwide and prompted an investigation by Parliament.

The investigations led to the disgracing of multiple directors of the South Sea Company and it was also revealed that some government ministers had accepted bribes and engaged in unethical speculative activity. There were also political ramifications that led to the appointment of the First Lord of the Treasury, Robert Walpole. Walpole instituted several measures to help restore confidence in the financial system, including confiscating the bulk of the wealth owned by individuals linked to the crisis. Proceeds helped alleviate the suffering of the bubble victims and Walpole was credited with saving the government from total disgrace.

The South Sea Company continued its operations but by 1750, it had sold most of its rights to the government. It was eventually abolished in 1858.

Lessons Learnt

The South Sea Bubble provides lessons for companies, investors, and regulators. For companies, it is important to have experienced directors rather than public relations enthusiasts. The South Sea Company entered into ambitious deals at a period where there were complex risks, such as war and political instability. Good governance is also essential as insider trading was one of the major catalysts of the bubble.

For investors, there is the lesson of due diligence and research. The company agents peddled misinformation (or rather exaggerations) and no one bothered about fact-checking or digging deeper. Investors also disregarded the management of the company as well as the size of the opportunity to be exploited. Stocks should be bought for value, and never for their hype. It is the responsibility of any investor to research the fundamentals of any investment and effectively assess the risks and rewards involved.

Regulators can also learn great lessons from the South Sea Bubble so as to prevent such crises and also protect innocent investors. There should be tough restrictions against insider trading and open misinformation peddled by corporations. However, it can be said that most regulatory challenges faced during that period have been resolved in the modern era.

Final Word

There is no doubt the South Sea Bubble is regarded as one of the most impactful and insightful bubbles in history. The bubble is very much a precursor to what can happen when easy credit is made available to holders of assets that are overvalued and inherently risky. Bubbles are usually caused by panic, and the South Sea Bubble clearly highlights some of the dangerous sources of panic in the market.