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The South Sea Bubble of 1720—Repackaging Debt and the Current Reach for Yield
Posted By Guest Author On November 13, 2013 @ 5:00 am In Investing,Markets | Comments Disabled
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.
. . . 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.
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.
David Skeie is a senior economist in the Bank’s Research and Statistics Group.
Posted by Blog Author at 07:00:00 AM in Crisis Chronicles 
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 post: http://libertystreeteconomics.newyorkfed.org/2013/09/crisis-chronicles-the-not-so-great-re-coinage-of-1696.html
 speech: http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm
 introduction: http://libertystreeteconomics.newyorkfed.org/2013/06/crisis-chronicles-300-years-of-financial-crises-1620-1920.html
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