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South Sea Bubble

The South Sea Bubble is considered one of history’s worst financial bubbles. A bubble is a situation in which prices for financial assets such as stocks or housing rise rapidly and far above their actual value. It is a phenomenon that happens when a certain aspect of the financial market makes the asset look very profitable in the short term, and influences market participants into investing in hopes of financial returns above that of other investing opportunities. As a result of the increasing prices, investors may opt to hop on the bandwagon which further increases demand and value of the asset. When investors begin to realize that a financial bubble is forming due to the high demand and overvalued price of the asset, the bubble may “burst” into a sharp into a sharp decline of the assets value and price. Investors who realize that a bubble has formed will sell their assets at high margins before the downturn. Once enough investors realize the potential downturn in the value of the asset, a market frenzy occurs in which investors who are looking to dump their assets may not be able to find buyers willing to speculate on increasing returns, and thus must hold onto the asset which is sharply declining in market value and in price. The investors who hopped on the bandwagon in the late stages of the financial upturn in hopes of short term financial gain are most negatively affected, and may see their entire investments fall to little or no value.

The South Sea Bubble started in 1711 after a war between Britain and Spain left Britain with 10 million pounds worth of debt. In desperation to borrow safely in order to maintain government operations, the British government proposed a deal to the South Sea Company, a private enterprise that reaped gains in international commerce. Britain’s debt would be financed by the South Sea Company at 6% interest meaning that every pound the British government borrowed from the private enterprise, the South Sea Company would eventually see 6% annual returns on their lending. The government also offered the South Sea Company a monopoly over the trading rights with the Spanish colonies in the “South Seas” now known as South America in order to establish and maintain a financially sound lending party.

The South Sea Company would assume exclusive trading rights with the Spanish colonies as it appeared that the deal would become very lucrative for the South Sea Company. It was perceived that the South Americans had high demand for British exports such as wool and fleece clothing in return for their abundance in gold and silver.

In order to finance its own operations, the South Sea Company began to issue shares of stock to the British public. The Company was in such position that the British public began aggressively pursuing the stock that was perceived to have little risk and much reward in the forms of both relative value investing and as an income producing asset from the Companies equity and dividends. Financial speculators were sold on the idea that the South Sea Company had full access to all of Spanish ports and many investing companies, as well as small household investors, began filling their financial portfolios with South Sea Company stock, and as a result of the increase in its demand, the value of the stock skyrocketed.

Although rumors from the Companies potential profits influenced a crazed market for the stock in which many of the largest companies and even investors from other European countries attempted to reap gains, the actual commerce and operations of the South Sea Company came to a halt in 1718. Britain and Spain went to war again in 1718 stopping all international trade between the two parties. Furthermore, the notion that the Company had access to all Spanish ports was in fact a fallacy as Spain would only allow trading with three ships per year in actuality during the years of operation.

As a result of the war, the management of the South Sea Company realized that their operations could not keep up with the value of their stock and they decided to start selling their shares before the public was aware of the overvaluation of the stock. Once word broke out that the Company’s management had begun to sell its stock in order to get out early, the bubble burst and investors began panic selling in order to dump the overvalued asset. The immediate panic selling led to low liquidity in the buying market and as a result, many companies and investors were left worthless. The bursting of the bubble left Britain and many of the surrounding countries who had invested in financial tools that relied on the Company’s stock in shambles and a full recovery was not in order for nearly a century.

 

Sources

Colombo, Jesse. “The South Sea Bubble (1719-1720) | Stock Market Crash!.”Stock Market Crash! | Learn about historic stock market crashes & why another crash is coming.. N.p., n.d. Web. 12 Mar. 2013. <http://www.stock-market-crash.net/south-sea-bubble/&gt;.

“bubble financial definition of bubble. bubble finance term by the Free Online Dictionary..” Financial Dictionary. N.p., n.d. Web. 12 Mar. 2013. <http://financial-dictionary.thefreedictionary.com/bubble&gt;.

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