The South Sea Bubble that Cost Isaac Newton $3 Millions
The story of how Isaac Newton allegedly lost £20,000 in the South Sea Bubble (or around $3 millions based on the money value in 2002–03) has become one of the most famous investment anecdote throughout history. It tells the perfect story of that even geniuses make bad investment decision.
I can calculate the movement of the stars, but not the madness of men.
Sir Isaac Newton
The South Sea Company’s share price rose to ten times its par value (£100 to £1,000) within a few months before it burst. To understand what really happened in the South Sea Bubble we first have to understand what is the South Sea Company.
Desperate Times, Desperate Measures
Two men are pivotal in the foundation of the South Sea Company — Robert Harley and John Blunt.
Robert Harley was a politician while John Blunt was an opportunist. (Think of him as the Jho Low of the South Sea Bubble Scandal)
When Robert Harley got appointed as the Chancellor of the Exchequer (equivalent of our Finance Minister), Great Britain was in huge debt thanks to wars. His first task was to keep the government afloat through the end of the year.
To understand how difficult his task was, we first have to understand that there were two major parties in the parliament, namely the Whig and Tory.
To raise capital, Harley had 3 viable options; 1) raise taxes, 2) borrow money from the Bank of England or 3) inject foreign capital.
Harley was a tory. Passing the bill for higher tax was difficult as it received resistance from the opposition party (Whig). Next, borrowing money from the Bank of England was also a hurdle as it was a Whig-controlled institution. The last option Harley had was foreign capital but this too was impossible because Great Britain was in wars with many other countries.
With not much option left for him, he turned to a less orthodox source — John Blunt.
First Taste of Success
At first, Robert Harley handed the right to sell state lottery to John Blunt. In return, Blunt delivered a kick-ass job with two very successful lottery sales campaign. He managed to secure the capital Harley so desperately needed while pocketing a handsome commission for himself.
The main driver behind his success was that he made sure every ticket was guaranteed a winning prize of at least £10 with a top prize of £20,000. But there was a catch, the prizes were paid out by instalments instead of one lump-sum. Therefore, the government was effectively holding the prize money as borrowings. Blunt was a man with very sharp financial mind despite his name.
The UK government was still paying interest for the debt due to the South Sea Bubble long after 1720. In 2015, UK announced to pay off its remaining debt. (Almost 300 years later)
Foundation of the South Sea Company
The funds that John Blunt managed to secure from the lottery sales was still a far cry from the government enormous debt.
So, the two of them came out with another plan for a trading company that would consolidate the government debt. This company will be controlled by Harley, Blunt and……..(wait for it)……….all their Tory friends (you bet).
With a Tory-controlled company in place, Harley can now bypass all the political hurdle.
How It Works
The government will pay the South Sea Company 6% of interest annually for taking care of its debt. This is lower than what they were initially paying to the private debt holders.
All holders of the government debt would be required to surrender their debt in return for the company shares. For example, Elizabeth surrendered the £2,000 she lend to the government few years ago. In return, she will receive the South Sea Company shares that were worth £2,000. By doing so, she gave up the principal (£2,000) and the right to receive future interest payment.
WAIT A SECOND.
Why would anyone gave up a more secure government bonds for a company’s share that they have never heard of? This company must be something, aye?
Here’s where the South Seas part kicks in.
Tales from the South Seas
In this deal, the South Sea Company was also granted a monopoly (an exclusive right) to trade in the South Seas. Everybody was hyped about this potentially lucrative enterprise especially given how well the Honourable East Indian Company was doing at that time.
There was one catch though. The South Seas mentioned here refer to all the ports in Central and South America, which were controlled by Spain, with whom Britain was at war with.
Although Harley did managed to end the war eventually via peace negotiation, the Spanish only gave the South Sea Company the permission for slave trading under the condition that they can only send one ship per year to these ports.
For crying out loud, the East Indian Company was sending fleet of ships every month for their business operation.
At this point, it is clear to the originators of the scheme that South Sea Company was really just a financial institution who only purpose was to manage the government debt.
Nevertheless, the truth was kept a secret and the potential for great wealth was publicized at every opportunity.
Too Big to Fail (or so They Thought)
In 1714, Queen Anne died without an heir. King George I was chosen as the successor and there was major change in the government. As a result, Harley fell out of his position.
Remember when I mentioned Blunt was an opportunist? He swiftly replaced most of the Tory board members in the South Sea Company with Whigs and even got the King’s son to replace Harley as the new governor.
In 1717, King George I had a fight with his son and removed him as the governor. Beyond Blunt’s wildest dream, the King elected himself as the new governor. Not only that, the Royal family was also investing in the company.
This was seen as a huge endorsement in the public’s eyes. The thoughts of the company failing was seemingly impossible at this point. (Spoiler: They were wrong)
Inflating the Share Price
In 1719, the South Sea Company announced its most ambitious plan and this is where the mania buying begins.
The company was proposing to take over most of the unconsolidated government debt, amounting to £31 million in exchange for issuing more company shares. Here’s how Blunt and his “crew” can exploit this plan.
Say the South Sea Company took on £1,000 debt from the government. Both the government and South Sea Company agreed that the share can be issued at £10 each. This means that the South Sea Company can issued 100 shares (100 x £10 = £1,000) to match the value of the debt they took.
If the share price increased to £20 each before the issuance. They were now able to fund £2,000 from the same 100 shares (100 x £20 = £2,000). The first £1,000 to cover the debt as planned and the additional £1,000 as their profits.
Now replace that £1,000 with £31 million and £10 with £100. Rise of £1 in the share price means that the company will be able to profit around £310,000.
To the Moon
Shares were given to politicians without them having to pay for it on the spot. By doing so, these politicians also had the interest to see the company share price rose so that could also participate in the profit taking process. When they choose to sell back their shares, they will receive the increase in market price as profit. EZ MONEY!
The South Sea Company even went to the extend of offering instalments plan and lending money to peasant so that they could afford the share and thus maintaining the buying frenzy. As a result, the share price went up from about £100 to almost £1,000 in just about a year!
The South Sea Bubble Burst
The South Sea Company was not the only company that was raising capital from investor in 1720. Due to the hype in the stock market, all kind of companies were created to join the party. Some were legitimate companies such as insurance company while others were straight up shady.
There was rumor stating that a company that went public as “a company for carrying out an undertaking of great advantage, but nobody to know what it is”.
Instigated by those who were supporters of the South Sea Company, the Bubble Act 1720 was passed in the parliament. This act was to prevent other companies from competing with the South Sea Company for investor’s capital. All these smaller companies were labeled as “unwarrantable practices” and being shut down by the government. Unfortunately, it backfired as investor who lost money in these companies started to sell off their South Sea Company share to cover debts.
At this point, the company was owed about 60 million pounds and with little to none left in their reserve. People had finally realized the lack of fundamental basis of the South Sea Company. The only reason that it was continuing to rise in share price was only because there was always a greater and greedier fool who was willing to buy it.
By September 1720, prices plummeted back to around £150. A lot of investors especially those who bought the shares using borrowed money went bankrupt and some even suicided.
Like any other historical event, the South Sea Bubble of 1720 serves as a good reminder to us investor and all policy maker.
One that reminds us to never invest in things that we do not understand. Especially if there is limited information about the investment.
Never trade with the feelings of FOMO. Invest responsibly by having all the numbers and facts to backup your decision. If you can’t do so for any of your investment, chances are they are not sound investment or you haven’t done your homework good enough.
“Be fearful when others are greedy.”