Most people in the stock market have heard about the South Sea Bubble, the first stock market bubble, which took place in 1720, but few people realize that the South Sea Co. was also one of the first ETFs in market history. Many people have seen a chart of the stock rising from 100 to 1000 within a few months, then collapsing back to 100. But what happened after the stock price collapsed, and why did the stock price rise so suddenly and then collapse to begin with?
The South Sea Company was a British joint-stock company founded in 1711 as a public-private partnership to consolidate and reduce the cost of British national debt. The company had a monopoly of British trade with South America, and the potential profits from this monopoly were used to justify the rise in price of South Sea Co. stock. When it was discovered the profits would not occur, which they did not, then the price of the stock collapsed.
The South Sea Company was, in modern parlance, a debt-equity swap. The British government had increased its debt significantly as a result of the War of the Spanish Succession. The government debt was over £50 million pounds, or about 100% of GDP. Following in the footsteps of John Law, who had created the Banque Royale in France to reduce the French debt, the British government decided to do the same. South Sea Company shares were backed by government bonds, would pay 5% interest, and unlike British government debt, South Sea Co. shares would have the potential for increases in dividends as the South Sea Company profited from its monopoly. The British government benefited because it reduced its debt, and holders of British government debt could benefit from a higher rate of return and the potential for capital gains. The conversion of British government debt to South Sea Co. stock was a win-win. When things are too good to be true, they are. If the Securities and Exchange Commission had existed in 1720, they would have arrested everyone associated with the South Seas Co. since they broke almost every rule in the SEC book. Rumors about profits were spread, members of Parliament were bribed, shares could be bought with a small down payment or no down payment, shares could be purchased at the par price of £100 and sold at the higher market price, etc. Shares were sold to members of the government at the market price without them having to pay for the shares. When the price of the stock rose, the shares could be sold at a profit. This cost the “investors” nothing, made sure their interests lay with the South Seas Co., and insured profits to the supporters of the company. Even George I’s mistress was allowed to benefit from this scheme. The rise in the price of South Sea Co. stock led to numerous additional companies emerging to take advantage of the stock market bubble. Almost all of these companies became worthless, and this led to the passage of the Bubble Act in June 1720. The Act required that a joint stock company could only be incorporated by Act of Parliament or Royal Charter. The prohibition on unauthorized joint stock ventures was not repealed until 1825. The Bubble Act limited potential competition and drove the South Sea Co. stock price £890 in early June.
The price finally reached £1,000 in early August, and sellers began to outnumber buyers. Liquidity started to dry up, in part because the first installments for shares purchased by investors on credit became due. By the end of September the stock had fallen to £150. Despite forays into the slave trade and Arctic whaling (an oxymoron for the South Seas Co.), the company never made a profit, but lost money, and as is always true of large companies that lose money, they sought subsidies from the government for their Arctic whaling, which they got, and they sought a bailout from the British government, which they did not get. After the 1732, the company’s slave trading and Arctic whaling were shut down. From then until 1855 when the company was liquidated, the South Sea Co. simply managed its government debt. After the Bank of England stock and East Indies Co. stock, the South Sea Co. stock was the third most traded stock on the London Stock Exchange for the rest of the 1700s, not for its monopoly profits, but for the steady income from government bond interest payments. In effect, the South Sea Company became an ETF for government debt, 250 years before ETFs became a mainstay of the US stock market. By 1855, the South Sea Co. had outlived its purpose and it was closed down. The chart below shows the history of the South Sea Co. from its inception in 1711 to its liquidation in 1855. Although the South Sea Co. will always be remembered for its bubble, it should not be forgotten that it also laid the foundations for the ETF mania of the twenty-first century.