GPEM 200506: Financial Crises Bubbles IV: South Sea

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GPEM 2005-06 Financial CrisesBubbles IV South
Sea

• Hans-Joachim Voth

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Outline

• Context and background
• Why look at a distant historical event in such
  detail?
• Where did the South Sea bubble come from?
• Why did it happen in 1720?
• Temin-Voth rational speculators and predictable
  sentiment
• Dale et al. irrationality
• Shea contract details

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The bubble in long-run perspective
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Mississippi bubble very similar
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Common problem government deficits
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Historical background

• South sea company founded in 1711
• Purpose to trade with Spanish America (Treaty of
  Utrecht 1713)
• Finance government debt
• Trade never amounts to much (a number of slave
  ships etc.) in 1718, ships and assets seized by
  Spain
• 1719 successful exchange of lottery tickets from
  1710 (government debt) for company shares
• Lower interest rate debt becomes more liquid
• Financed by new share issue profit for company
• Higher market value of debt for creditors
• 1720 offer to exchange most of remaining
  government debt
• Total remaining debt approx. 50 million pounds
• 18.3 held by Bank of England, East India Company,
  and South Sea Company
• 16.5 redeemable, privately held debt
• 15 irredeemable long 72-87 years maturity,
  short 22 years

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Historical background - 2

• Debt exchange agreed with Treasury December 1719
• Government will pay 5 until 1727 and 4
  thereafter
• Bank of England starts to bid for contract,
  January-February 1720
• Initial offer South Sea Company 3 million pounds
  for the debt conversion privilege
• Final offer 7.5 million
• Parliament (and the Court) bribed February-March
  1720
• Total expense probably around 1.3 million pounds
• Shares "sold" to politicians, mistresses of the
  King, ministers with no cash changing hands,
  often below market price similar to granting a
  free option to them
• Equity raised in four subscriptions,
  April-September 1720
• Total amount the company can raise 20 million
• Payments not made in full between 1/10 and ¼
  paid initially
• Conversion rate not set
• Higher market price means higher "profit" (equity
  capital left for other purposes)
• _at_135, 20 million in government debt can be
  acquired for 14.8 million in stock (face value),
  leaving 5.2 million for other purposes
• Massive lending against own stock (restricting
  free float)

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Some difficulties in determining underlying value

• Flying Post from April 9th, 1720
• with the share price of South Sea stock at 300,
  its intrinsic value would be 448
• at 600, it would be worth 880
• the higher the price, the more cheaply
  bondholders could be bought out, and the higher
  the value of shares
• Garber (2000) "the episode is readily
  understandable as a case of speculators working
  on the basis of the best economic analysis
  available and pushing prices along by their
  changing view of market fundamentals."

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Trading conditions

• The offices of the South Sea Company very soon
  found it impossible to keep abreast of the
  transfers of stock reported to them on the three
  days a week appointed for settlements. This
  sheer physical inability to register changes of
  ownership in the stock naturally encouraged
  credit trading and speculative forward sales,
  particularly when, as happened from time to time,
  the transfer office had to close in order to
  catch up with the existing arrears, and bargains
  could only be made for the opening of the
  books.
• John Carswell, The South Sea Bubble

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VALUE OF THE SOUTH SEA COMPANY, AUGUST 1720
164
in millions of pounds
87.9
at 4
at 8
20
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The financial situation of the South Sea Company,
end of August 1720

• Market value of South Sea shares 164 million
• Claims
• 1.9 million to 1727
• 1.5 million thereafter
• at 4 ? 40 million
• at 8 ? 20 million
• Cash receivable from investors
• 70 million from subscribers
• 11 million in lending against stock
• Liabilities
• 7.1 million for the conversion privilege
• 6 million in debt
• Net - 56.1 million to - 74.1 million
• at 4 -- 2.25 million in additional profit p.a.
  required to close gap
• at 8 -- 4.5 million

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A bubble?

• Guaranteed payments worth 13-24 of market
  capitalization in September 1720
• 50 of "assets" were simply claims on equity
  owners, with low probability of being paid up
  (especially when prices turned down)
• Required profit to close valuation gap very large
  no other corporation in English history had
  made profits on such a scale, not even for a
  single year, let alone continuously
• Ponzi scheme element
• South Sea Company pays dividend out of equity
  just raised from subscription
• lends against stock from fresh equity
• Underlying profitability minimal
• Not even Garber claims that the valuations in the
  summer of 1720 can be rationalized by
  expectations of future dividends expected price
  increases of the asset itself must have been key

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Three competing hypotheses and observable
implications

• Actions driven by irrational impulses
• gt Does as well as someone buying and selling
  randomly throughout the year
• Investment decisions severely constrained by
  trading/settlement microstructure, short-sale
  constraints, etc.
• gt Sells off its holdings as soon as
  overvaluation becomes substantial, but does not
  go short for most of the bubble
• Behavior best explained by predictable investor
  sentiment riding the bubble, despite knowledge
  that overvaluation is massive
• gt Continues to hold stock throughout the bubble
  episode, selling periodically possibly missing
  the optimum time to sell

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Data and the early history of Hoares

• Hoare's a private bank on Fleet Street, steps
  from the LSE
• Moved to its current location in 1690 origins as
  a goldsmith in the 16th century "at the sign of
  the golden bottle" Cromwell's daughter banked
  with Hoare's banking business since 1672 started
  by Sir Richard Hoare
• Archive used by permission of the current
  managing partner, Henry Hoare
• Two main sources
• Account ledgers
• Balance sheets

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The sign of the golden bottle and Sir Richard
Hoare
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Evidence A goldsmith bank in the South Sea bubble

• We look at positions held by one goldsmith bank,
  Hoare's
• Initially a goldsmith, with a sideline in
  pawnbroking
• Turns to lending from the 1690s
• Total size of balance sheet in 1720 262,000
  pounds peak valuation of South Sea company
  164,000,000 pounds
• Maximum position March 1720, 1.1 of South Sea
  shares average for the year 0.4 average
  trade 0.09 of shares outstanding Hoare's is a
  substantial investor, but by no means big enough
  to dominate the market
• Why a goldsmith bank?
• Amongst the most sophisticated investors in the
  early modern English market
• Owners have high-powered incentives unlimited
  liability partnership, deposit-taking
  incentives similar to hedge funds today
• Data availability trading records are rare, even
  today unusually lucky find
• If anyone managed to go short, it was goldsmith
  banks and other brokers
• Not a small group in 1700, as many as 42 banks
  in total 13 "West End" bankers in 1725
• Goldsmith banks as close to the ideal of
  rational speculators as one can expect during
  the the eighteenth century

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The Technology Bubble
NASDAQ Combined Composite Index

• Ofek-Richardson (2001WP) Valuation of Internet
  stocks implied
• Average expected earnings growth of about 3,000
  in ten years, assuming that they already achieved
  old economy profit margins
• Zero percent cost of capital for ten years
• How unique was the tech bubble?
• How unique were the conditions that contributed
  to the bubble's birth and growth?

Chart (Jan. 98 - Dec. 00)
38 day average
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Comparing the South Sea bubble and the dotcom
mania

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Outline Preview

• Theoretical Context and Related Literature
• Historical Background and Data
• Empirical Results
• Hoare's maintained a significant positive
  exposure during most of the bubble episode
  skillfully anticipated the downturn, by selling
  out near the market peak
• Timing not quite perfect sells too early in the
  year, and then too late (comparison with hedge
  funds during the tech bubble shows similar
  behavior)
• Significant outperformance of buy-and-hold, and
  momentum strategies
• Cross-sectional evidence Outperformance most
  impressive in the most speculative assets
• Information from customers, insider trading
  probably not key
• Strong, indirect evidence that Hoare's believed
  the market to be overvalued
• Conclusions

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Trading activity at Hoare's in 1720

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South Sea stock price and Hoare's trading

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Hoare's holdings and South Sea prices
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Returns following Hoare's trading

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Returns following Hoare's trading

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Hoare's daily return vs. the return on South Sea
stock

Buy and hold
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Jensen's alpha Hoare's and momentum strategy

• While the value of South Sea stock is
  increasing beta is 0.94 for unleveraged
  portfolio, 1.67 for leveraged
• While returns are negative beta is 0.57
  unleveraged, 0.87 leveraged
• Outperformance from Jensen's alpha implies
  annualized return of 54 to 222

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Profit/Loss, from 6 months prior to market peak
to 6 months after

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• Figure 6 Performance of a copycat fund that
  replicates hedge fund holdings in the NASDAQ high
  P/S segment
• From Brunnermeier and Nagel 2003

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Hoare's timing not perfect, but similar to hedge
funds during the tech bubble
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Hoare's trading in other shares

• Bubble in progress in other shares, too
• If predictable investor sentiment is crucial,
  then the most overvalued/"hot" shares should show
  most of it greatest opportunity for Hoare's
• This is what we find trading success is greatest
  in the most speculative assets
• Hoare's earns 200 over 2 months in shares of the
  Royal African Company
• Ram's Insurance (one of the "bubbles"), 43 in 17
  days
• Bank of England 51 annualized
• East India Company partly negative returns
• Similarity with hedge fund results Brunnermeier
  and Nagel only find outperformance for shares
  with very high P/S ratios

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What determined success?

• Anecdotal evidence few connections between South
  Sea Company and Hoare's
• None of the "insiders" listed in the literature
  directly connected with Hoare's
• No politicians of the time deal through Hoare's
• Lord Carlton buys 6,000 shares immediately before
  Parliament debates the conversion Hoare's buys
  9,000 shares during the two weeks before and
  after, but timing is off
• Quantitative tests
• How well did Hoare's do during periods when its
  customers traded?
• How much of Hoare's trading can be predicted from
  trading of its customers?

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Predicting Hoare's trading behavior Poisson
regressions

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Customer "flow" was not key to Hoare's trading
performance
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Detecting Overvaluation

I verily believe that there is no real
foundation for the present, much less for the
further expected, high price of South-Sea stock
and that the frenzy which now reigns can be of no
long continuance in so cool a climate It seems
to be the universal opinion within and without
doors of Parliament that the present price of
South Sea Stock is much too high. -- Hutcheson,
Collection of Calculations and Remarks Relating
to the South Sea Scheme, March 1720
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Greater fools

This comes to good Mr. Warner, to lett him know
that I am allmost sure, I can mack an advantage
by bying in the South Seas with the hundred and
four score pounds is still in your hands so I
would bye as much as theat will bye today, and
sell it out agane next week, for tho I have no
oppinion of the South Sea to contineue in it I am
almost certine thus to mack sum litell advantage
to her that is good Mr. Warners reaell friend
-- Dutchess of Rutland, letter to her broker,
March 1720
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Hoare's lending against South Sea stock

• Similar evidence from interest rates on brokers'
  loans
• January 5 per annum
• April 10 per month
• From May 1 per day
• September 5 per month
• (from Hutcheson)

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Eventual collapse

• From September 1720, growing pressure on share
  price Company lends frantically against shares
• Bubble Act enforced by Company supporters
• Sword Blade company collapses
• "coordinating event" that allows rational
  speculators to attack simultaneously
  synchronization risk goes to zero
• Most stock held on margin "Greenspan put"
  equivalent through renegotiation of payments
  payment to treasury cancelled, shares
  redistributed

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Conclusions

• The South Sea bubble a useful historical episode
  to isolate the behavioral/market microstructure
  aspects that contribute to overvaluation episodes
• Only tentative conclusions possible based on the
  behavior of one investor
• Hoare's apparently thought South Sea stock was
  overpriced -- warnings about overvaluation
  available for a long time Hoare's limits amount
  of lending against stock during the run-up in
  prices, suggesting that it doesn't expect the
  bubble to last
• Nonetheless, the bank did not attack the bubble,
  but maintained (or increased) its positions
  during the run-up of prices. Nonetheless did
  spectacularly well much better than hedge funds
  in 1998-2001.

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Conclusions - 2

• In this case, market microstructure and delegated
  portfolio management were not responsible for the
  bubble inflating.
• Rational bubbles story very unlikely lending
  against stock speaks against this interpretation
• Balance of probabilities suggests that insider
  trading was not key, and that Hoare's could to
  some extend anticipate investor sentiment
• Cannot distinguish conclusively if return
  predictability was driven by insider knowledge,
  second-guessing of noise traders, or of
  sophisticated investors

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Dale et al.

• The premise Markets can go mad
• The argument
• Violations of no-arbitrage condition (idea
  similar to 3Com-Palm)
• Why would options systematically trade at prices
  different from those of shares (adjusted)?
• Background how to invest in the south seas
• Pricing equations
• Some observations, Garber style

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Whats wrong with the Dale et al. argument?

• Contrast with 3Com
• Clear market microstructure limitation there
• Mispricing disappears
• It is not impossible to explain (Cochrane)
• Doesnt pass the smell test

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