Thursday, July 19, 2007

South Sea Bubble

Market crash story 2

Happens in 1700s in England. Haha, another lesson to learn from the past. Don't ever say that this time the market is different...human psychology is always the same and hence the market will always be the same.

Read and learn :)

Dubbed the “Enron of England”, the South Sea Bubble was one of history’s worst financial bubbles.

The mania started in 1711, after a war which left Britain in debt by 10 million pounds. Britain proposed a deal to a financial institution, the South Sea Company, where Britain’s debt would be financed in return for 6% interest. Britain added another benefit to sweeten the deal: exclusive trading rights in the South Seas. The South Sea Company quickly agreed, because of the proximity to wealthy South American colonies. The company planned on developing a monopoly in the slave trade. Additionally it was thought that the Mexicans and South Americans would eagerly trade their gold and jewels for the wool and fleece clothing of the British.

The South Sea Company issued stock to finance operations and gain investors. Investors quickly saw what they perceived as value in the monopoly of the South Seas. Shares were quickly snatched up from the start. The South Sea Company, seeing the success of the first issue of shares, quickly issued even more. This stock was rapidly consumed by the voracious appetite of the investors. Investors had no quibble, despite having a highly inexperienced management team. All they saw was that the stock was going to the stratosphere. Many investors were enamored by the lavish corporate offices that had been set up. This painted an image of success and wealth in the eyes of shareholders. At this point in England’s inudstrial revolution, investment capital was plentiful. It became extremely fashionable to own South Sea Company shares.

The management team of this company started hyping the stock, spouting illusions of grandeur to the investors. Speculation became rampant as the share price kept skyrocketing. It was thought that this company “could never fail”. The management developed rumors that the South Sea Company had been granted full use of Latin American ports, by Spain. The truth was, however, that Spain only allowed 3 ships per year. Unrealistic expectations were the norm among South Sea’s investors and speculators.

Much like Enron, widespread corruption occurred among directors, company officials and their political friends. Ipo’s started everywhere as other companies tried to profit from the stock boom, as well. These companies proclaimed everything from building floating mansions to distilling sunshine from vegetables. These shares were snatched up by speculators as well. Many people became aristocracy almost overnight. Sir Isaac Newton, the scientist, had foreseen a coming stock market crash and sold his shares early with a profit of 7,000 pounds. Aftwerwards, however, Newton saw the bubble keep inflating and bought more shares.

In 1718, Britain and Spain went to war again, stopping all chances for trade. Investors were not daunted, as they kept buying. Investors from other European countries started frantically scrambling for South Sea’s shares, as well.At this point the company leaders realized that the South Sea Company wasn’t generating any profit from its operations. More emphasis was placed on making money from issuing stock than from actual commerce. For example, large shipments of wool were left to decay as a result of careless shipping mistakes. It was at this point that management realized that the shares were incredibly overvalued relative to the profits. They decided to sell while other investors were still unaware that the company was profitless.

Eventually word broke out that the management team had sold out completely. Investors were left holding the bag. Panic selling of the worthless shares immediately ensued. Fortunes were lost in a heartbeat. The stock market crash had started and all other stocks prices were obliterated, as well. Isaac Newton lost over 20,000 pounds of his fortune. As a result of this crisis, he stated “I can calculate the motions of heavenly bodies, but not the madness of people”. Jonathan Swift, who also lost a fortune, was inspired to write Gulliver’s Travels, which is a satire about British society. The British government avoided a banking crisis due to its standing as the financial powerhouse of the world. The government worked to stabilize the banking industry. The issuing of shares was outlawed to prevent any future bubbles. This law was in effect until 1825. Despite all of the efforts of the government, Britain’s economy was in shambles. The economy didn’t fully recover until one century later. Several generations were adversely affected by the stock market crash. The corporate management con artists fled to other countries with their fortunes.

Every bubble and market crash has the same important elements. Greed and unrealistic expectations will continue to foul people’s judgment as it always has.