FINANCIAL CRISES PAST & PRESENT John Munro, University of Toronto

1. FINANCIAL CRISES PAST & PRESENTJohn Munro, University of Toronto The South Sea Bubble of 1720 and its relationship to the current financial crisis: an old and still current story of greed, fraud, and stupidity

2. LEVERAGE AND LIQUIDITY • From: UBC Faculty Pension Plan: Pension News, Third Quarter 2008 Edition • Two concepts are important in understanding the events of the past year: • leverage and liquidity:

3. The UBC Pension Plan News: Leverage & Liquidity • LEVERAGE is the use of borrowed funds to purchase assets greater in value than the initial amount of equity. • A common use of leverage is by individual homeowners who might purchase a $500,000 home with $100,000 of equity and $400,000 of borrowed money. The leverage magnifies the rate of return: so, if for instance the value of the home increased by 20% to $600,000, the homeowner’s equity increased by 100% to $200,000.

4. Leverage & Liquidity • LIQUIDITY is the ability to access cash, investments or credit to finance transactions by individuals, businesses and governments. • If credit is not available, the ability to transact business becomes more difficult. As the financial soundness of individuals, companies (especially financial institutions) and even governments is questioned, vendors and lenders become increasingly reluctant to transact business because of the uncertainty of being paid. • Business slows down, and companies that need credit to operate, but find it inaccessible, can fail.

5. More Current Views:William Robson, CD Howe • Forced Liquidations and the Financial Crises • ‘Forced liquidations – urgent cash needs that make people unwind arrangements that they would rather leave in place – are a principal cause of the current financial crisis. Savers sell at a loss and financial institutions face sudden demands for liquidity, which suddenly becomes scarce.’ • William Robson, President and CEO of the C.D. Howe Institute: in • The Globe and Mail, Wednesday, 5 November 2008.

6. THE SOUTH SEA BUBBLE of 1720: Origins of joint stock companies • 1. 1553: formation of the Muscovy (Russia) Company • England’s first joint-stock company (probably also the first in Europe) • Capital raised by the sale of shares of ownership: jointly held stock • England’s first long-distance overseas trading company • a chartered incorporated joint-stock company: with a monopoly on Russian trade • 2. 1600: Incorporation of the East India Company: with a monopoly charter on Asian trade • 3. 1694: Incorporation of the Bank of England: also a joint-stock company • with a dual monopoly: on government banking and joint-stock banking • in return for a permanent loan of £1.2 million at 8% (6% from 1709, 3% from 1742) • initial stage of the Permanent Funded National Debt (with 1693 Million Pound Loan)

7. The South Sea Bubble: Origins • 4. 1695: formation of the London Stock Exchange (LSE): on Lombard Street •  Note: a secondary market for trading in (buying and selling) previously issued shares •  by this time, England had 137 joint-stock companies, most of which were unincorporated. • 5. 1698: New East India Company Incorporated: • thus, it broke the original East India Company’s monopoly on Asian trade. • in return for a permanent loan of £2.0 million at 8%: also part of the national debt • 6. 1709: Incorporation of the United East India Company • original East India Co forced the New East India Co to amalgamate (a ‘take-over’) • in return, for another permanent government loan of £1.20 million at 6%

8. The South Sea Project: to take over the national debt • 7. 1711: Establishment of the South Sea Company: third of the Three Sisters • .chartered, incorporated joint stock company with a monopoly on South Pacific trade (lucrative Mexico-Philippines-China trade, controlled by Spain) • .real objective: to take over all the outstanding national debt not held by the Bank of England and the East India Company • .converted six series of English short debt, worth £9.471 million – paying interest annually at 6.25% to 9.0% – into 5% perpetual stock of the South Sea Company • .WHY? Why would recipients find this conversion beneficial? • .beginning of a nine-year stock market boom on the LSE

9. The South Sea Co Project: to take over the National Debt • 8. 1719-1720: South Sea Company attempts to convert the remainder of the outstanding national debt (not held by the Bank of England, East India, and South Sea Cos.) • .the total proposed conversion was £31,580,888 = 64.18% of the national debt • .remaining £18,321,872 = 26.72%: already held by the Three Sisters • .takeover to be financed by a new IPO: Initial Public Offering (not on the LSE) • .but the proposed conversion terms stipulated that the outstanding issues of government debt, at par value, were to be converted into South Sea Co stock at prevailing market prices on the London Stock Exchange

10. The South Sea Bubble begins • .South Sea Co. employees operated a ‘boiler room’ to drive up stock prices: for, the higher the market price of the shares, the fewer shares would be surrendered • .hence the beginning of the ‘bubble’, which spread to other stocks • .virtually everyone had always bought shares on 10% margin: borrowing the rest from their brokers as demand ‘call loans’, but pledging all assets as collateral • If a buyer paid £10 for £100 share, and value rose to £120, buyer made a 200% gain: i.e., a £20 gain on his £10 investment. • Hence the ‘leverage’ • .with the Bubble mania, most who bought shares did so in the hope of quickly reselling them at higher prices, i.e., for capital gains, not for the 5% dividends

11. The 1720 Bubble Act: the Bubble is Pricked • 9. The Bubble Act of 1720: statute 6 George I cap. 18, • .South Sea Company requested (and paid for) the act: to limit the activities of other financiers and speculators who were similarly raising capital by selling new IP0s • .Act restricted the right of marketing shares, on the London Stock Exchange, from 24 June 1720: to just those companies possessing a legal charter of incorporation • .The statute also required those companies to operate solely within their charter • .Most joint stock companies lacked charters of incorporation: i.e., those held by the Three Sisters and a very few other companies (e.g., The Hudsons’ Bay Company) • . • August 1720: South Sea Co. launched a legal suit against three insurance companies for violating the terms of their charters: • and thereby committed financial suicide

12. The Bubble Crisis and the1720 Stock Market Crash • 10. The Bubble Crisis and Stock Market Crash: August - December 1720 • .Result: PANIC! stock prices for the threatened companies plummeted • - York Buildings Insurance: fell from £305 to £30 • - London Assurance: fell from £175 to £30 • - Royal Exchange Assurance: fell from £250 to £60

13. 1720 Stock Market Crash: Reasons • Financial climate of pessimism and widespread fear not the only reason • Major Financial Reason: once prices fell, brokers who held stock as collateral for ‘call loans’ immediately sold the stocks and demanded that buyer-borrowers pay up • Those required to redeem their call loans were forced to liquidate their assets, beginning with their good stocks (e.g., those of the Three Sisters, Royal African) • Prices of other ‘good’ stocks began to fall sharply: Gresham’s Law of Finances [Gresham’s Law: bad money drives out good money] • Obviously South Sea shares fell the most: as the most inflated • hence a system based on LEVERAGE (margin) led to a LIQUIDITY CRISIS

14. Consequences: 1720 - 1825 • 11. The Consequences were many and manifold: • above all, Parliament used the ‘Bubble Act’ to prevent the formation of joint-stock companies (except for canals in 1780s) to 1825. • Industrial Revolution (1760 – 1820): new industries had to find alternative methods for capital financing • Chiefly for fixed capital: mortgages and private loans • For working capital : discounting & short term lending from the new ‘Country Banks’ • Without joint-stock and branch banking, as the Scots enjoyed, hundreds of English banks failed: 93 alone (out of 715) in 1824 • Hence: abolition of the Bubble Act in 1825 & repeal of Bank of England’s monopoly in 1826

15. The South Sea Bubble: Graphics

17. Dilbert on the Current Crisis

18. Governments Debts Exchanged for 5% South Sea Company Stock in 1711 in pound sterling • Category Type of Debt Amount Percent • 1a Navy and Victualling to Michaelmas 1710 5,130,539 • 1b Ordnance to Michaelmas 1710 154,325 • 1c Transport office to Michaelmas 1710 424,791 • Subtotal 5,709,655 60.28% • 2a Army and Transport debentures up to 1702 987,157 • 2a accrued interest on these debentures to 1710 31,500 • 2b Shortfall in coal duties to pay loans: 1697, 1702 12,025 • 2c arrears in subsidy to Elector of Hanover 9,375 • Subtotal 1,040,057 10.98% • 3a Navy, Ordnance, Transport Debts 1710 378,859 • 3b Interest of debts for 1710-1711 85,000 • Subtotal 463,859 4.90% • 4 Principal and interest on short-term loans 1710-11 • 1,371,428 14.48% • 5 Sum for current supply 500,000 5.28% • 6 Interest on whole debt for 1711 386,325 4.08% • TOTAL 9,471,324 100.00%

19. Structure of British Government Long-Term Debt in 1719 • in pounds sterling (current values) • Category of Debt • 1 Debt Owed to the ‘Three Sisters’ (Corporations) Totals Percent • 1a Bank of England 3,375,028 6.76% • 1b East India Company 3,200,000 6.41% • 1c South Sea Company 11,746,844 23.54% • sub-total 18,321,872 36.72% • 2 Redeemable Government Stock 16,546,202 33.16% • 3 Annuities • 3a 99 year annuities • (@ 20 yrs purchase) 666,566 5.000% 13,331,320 26.71% • 3b 32 year annuities 121,669 7.143% 1,703,366 3.41% • subtotal: annuities 15,034,686 30.13% • 2 & 3 Sub-total: gov’t stock & annuities 31,580,888 64.18% • TOTAL 49,902,760 100.00%