SOUTH SEA COMPANY AND MISSISSIPPI

COMPANY

FAMOUS FIRST BUBBLES

EVAGELIA TSANTILA
CONTENT
Mississippi Company
 Overview of the episode

 John Law’s system

 The most crucial events

 Money and prices

 Peak and Collapse

 Look in the Literature

Rationality
Role of equity and government
South Sea Company
 Overview of the episode

 Financial operations

 Price collapse

 Look in the Literature

Rationality
Role of options
Conclusions
Questions
ECONOMIC FRENCH ENVIRONMENT
 18th century French economy was depressed-high
debt-high taxes

 France controlled Louisiana and Mississippi

 Appearance of John Law with new monetary and

economic ideas(1715)
JOHN’S LAW
FINANCIAL SYSTEM
Law’s system=“experiment in
public finance”

 Two components:
1)Conversion of public debt
into government equity
2)Replacement of the existing
commodity money with paper
money
LAW’S FINANCIAL ACTIONS
 June 1716 : “Banque Generale”,issued bank notes
 August 1717: “Compagnie d’Occident”, monopoly
on trading with Lousiana and Mississippi
 January 1719: became “Banque Royale”
 May 1719: “Compagnie des Indes”, monopoly
with countries outside Europe
 July-October 1719: Right to mint and collect taxes
THE MOST CRUCIAL EVENTS AT 1719-
1720
 “Banque Generale” and “Compagnie des Indes”
merged
 Law became France’s Finance Minister

 The company reimburse the most of the national

debt(1500 million livres)
 Law’s bank notes became the sole currency in
France
 The Collapse
BACK TO LAW’S MAIN ELEMENTS
1)Conversion of government debt into Company’s
liabilities:
o Perpetual loan of 1600mL at 3% How?

o Borrowed the money from the public(by selling bonds)

o Later changed strategy and turned to equity

o What was his scope?

As Garber states: “Aquiring the debt he would create a
huge “fund of credit”,a steady income flow from the
government,which could be used as equity, against any
potential commercial venture of the Company”
FINANCING THE AQUISITIONS

Issues of shares

 June 1717-Dec 1718: 200,000 shares at 500L each, payable

in government bonds
 June 1719: 50,000 at 550L each in cash, (50L down and the
rest payable in 20 monthly installments)
 July 1719: 50,000 at 1,000L each in cash, (payable in 20
monthly instalments)
 Sep–Oct 1719: 300,000 at 5,000L each in cash, payable in 10
monthly instalments (options*)
2) PAPER MONEY
 LAW’S BELIEF: metallic money was inferior
and wasteful, reduce of liquidity
 SOLUTION: replacement by paper money or by
a highly liquid, interest-bearing security
 EXPECTED RESULTS:increase the money in
circulation, meaning increase in commerce.
MONEY AND PRICES

There are two ways to measure the depreciation of

paper money:

1)Against silver coin

2)Commodity price index
MISSISSIPPI BUBBLE
PEAK POINT
 At the peak of the Company’s value many
investors wanted to convert their capital gains
into gold
 Not enough gold
 Restriction of any payment in gold that was more
than 100 livre
 Bank notes became the legal tender
 Doubling the supply of money(inflation*)
COLLAPSE TIME
 Devalued shares in the company in several stages
 Bank notes was reduced to 50% of their face value
 September 1720 the price of shares had fallen to
2,000 livres and to 1,000 by December
 Law's enemies tried to take control of the company
 The end, September 1721 share prices had dropped
to 500 livres (beginning)
 Click icon to add picture

MISSISSIPPI BUBBLE MONEY AND PRICE

DATA
 QUESTIONS RELATED TO MISSISSIPPI BUBBLE
1) Why would, contrary to popular belief, the Mississippi bubble might not be an
irrational bubble?

 Not a classic example of a bubble in the modern sense of word

 Law’s ambition to achieve radical innovations

 Law manage the market’s expectations more and more

 Unrealistic expectations , too optimistic climate

 Company was overvalued by Law himself, not by an irrational market

 Investors were using all the available information

 Success, Popularity and confidence

 Support by the King

 Government attempted to rise Law’s reputation

Garber writes: “ There is a difference between uncertainty about the future which
drives innovators, risk-taking entrepreneurs and eventually markets and mob
psychology”
VELDE(2004)
What is the role of government equity and money in the
Mississippi share price?

 The conversion was simply a swap of government bonds, because

SSC could never demand repayment of the capital, but the
government could reimburse at any time
 Shares stopped to be sold for cash, but only for government bonds
 The observed share prices were not “pure”
 Government enjoyed the benefits of lower interest rates
 The largest component of revenues (almost two thirds) was the
king’s debt.
 Company’s powers and monopolies derived from the King’s will.
 Generally, the success of Law’s policies depended on the relation
between the King and the Company
 Law’s ability to print notes and at the same
time create demand for them
 Reduce of metallic coins

 Increase of supply money

 Law used money creation to support the price

of shares
 The price support policy was officially
stopped, after the prohibition for lending to the
King
THE END

Law’s scheme failed in the French economy…..

Although, it repeated a few years later in

England
SOUTH SEA: A TRADING COMPANY
BRITISH ECONOMIC ENVIRONMENT
 In 1720 high debt 50 million pounds
 11,7 millions held by the South Sea
 Other important corporations Bank of England
and East India Company
 South Seas areas was Spanish colonies in the
South America
THE DEAL

 March 1720 South Sea won to refund the debt

and to acquire the monopoly on British trade with
South Seas. How?
 Expansion of the number of shares
-For each 100£/year of long annuities→increase at par value up
to 2000£
-For each 100£/year of short annuities →increase at par value
up to 1400£
-For each 100£ par value of redeemables→increase stock issue
by 100£
 The interest rate was approximately 5%
ROLE OF THE PARLIAMENT
 The company was obligated to pay “bribes” to
leading members of Parliament(1.1mil.£)
 Gave cash loans at many members of Parliament
 Parliament’s member purchased a large number
of Company’s shares(17% of the additional
shares)
 Full support
SOUTH SEA’S FINANCIAL OPERATIONS(1720)

 21 March:1st passage of the refunding act (7,5 mil. £)

 April: Finance bribes and loans How?
Time to subscriptions:
1)14th 22,500 shares at 300£
2) 28th 15,000 shares at 400£
 19 May:1st debt conversion

“According to Scott market value of a long annuity was 1600£ prior to 3373£ after the
conversion”
 17th June : 3rd subscription OPTION
OPTION
S???
S???
3)50,000 shares at 1000£

 24th August :4th subscription

4)12,500 shares at 1000£

 The company acquired 85% of the redeemables and 80% of the irredeemables.
SOUTH SEA BUBBLE
THE PRICE COLLAPSE
 Market value of all shares
31 August:164 mil.£
1 October :61 mil.£
 What were the reasons?
1)Installments from the 1st and 2nd subscription were required
2)The increase of “bubble companies” NON
like Royal Assurance and London Assurance which EXISTEN
T
tried to “steal” South Seas’s investors
LIQUIDI
3)The Bubble Act in June 1720: TY
ban the formation of unauthorized corporations
4)News about Mississippi co and Tulipmania

 31 August 1720:Final Collapse

TIME AFTER THE COLLAPSE
• Shareholders became hostile
• Parliament turned against
• Redistribution of shares
• Parliament took some wealth from the
Directors(2 mil.£)
• Wrote off the conversion privilege of 7.5 mil.£
RATIONALITY
Why would, contrary to popular belief, the South Sea bubble might not be
an irrational bubble?
Value of the Company can be justified:
o extremely optimistic investors
o Law’s theory: FUND OF CREDIT AND COMMERCE EXPANSION
o Generally accepted rise above the fundamental price
o Using all the available information
o Success, Popularity and confidence
o Support of the King and Parliament

Garber in his own words: “The bubble interpretation has relegated the far more
important Mississippi and South Sea episodes to a description of pathologies of group
phycology”……“It is curious that economists have accepted the failure of the
experiments as proof that the investors were foolishly and irrational wrong”
SUPPORT EVIDENCE HARRISON(2001)
-Investigation in the methodology of equity valuation
at the time of South Sea
-Pamphlet press, written to influence the government
policy, criticize the stocks
-Harrison states that there were different opinions
about the “right”, the so-called “Intrinsic Value”,stock
price of SS but all of them are calculated in the same
way
-Dividend discount model: Profits were discounted at
the rate of interest, the investors were awared of the
relation between interest and asset prices
-The majority disagreed about SS’s current annual return and the
projection of future profits
Projection means : Dividends payments
Future prospects
-Harrison mentioned that high prices can be justified by the “strong
future monopoly profits”
-He also believed that:
-the conversion of government debt
-the company’s financial strength
-the support of the king and Parliament
contributed to the overvaluation of shares

In his own words: “My main point is that even if the bubble were partly
attributable to investors who neglected fundamentals, it would be wrong
to conclude that investors in 1720 were somehow less savvy or rational
than investors today.”
LITERATURE VIEWS-THE ROLE OF OPTIONS
 Gary Shea(2007):
-Response to DJT article, irrationality in financial markets and
the legal formation of options
-provide us efficient proof that :shares and subscriptions of
South Sea “have built” options into them
Basic hypothesis:
Shea examines the enforcement of subscription contracts in the
relevant Act(Geo. 1, c.4 ) and found that the subscribers were
not forced to deliver the raised money
-Shea also demonstrates the size of counterparty risk in forward
financial contracting
CONCLUSIONS
 Indeed both financial experiments failed.
 Improvements at theoretical fundamentals

 Contribution in the knowledge of market

 Need for directors-managers with well structured
financial skills
 Further explanation and cooperation of various
fields of sciences are required
PROBLEMS FOR THINKING
 Do we learn anything from the Mississippi and South
Sea Bubbles?
 Was Law’s system a fraud?

 To what degree Law was aware of his financial theory

 Can we find similarities in the way of trading the

options nowadays?
 Can we find similarities to the later bubbles?
QUESTIONS?