Originally posted on Tuesday, December 10th, 2013
Two erudite and discerning officials affiliated with the Federal Reserve Bank of New York — the bellwether of the Federal Reserve System — have posted another scholarly essay in their series entitled “Crisis Chronicles.” An excerpt from the fine, and immediately relevant, work of James Narron, senior vice president and David Skeie, senior economist:
THE SOUTH SEA BUBBLE OF 1720—REPACKAGING DEBT AND THE CURRENT REACH FOR YIELD
In 1720, the South Sea Company offered to pay the British government for the right to buy the national debt from debtholders in exchange for shares backed by dividends to be paid from the company’s debt holdings and South Sea trade profits. The Bank of England countered the proposal and the two then competed for the right to buy the debt, with South Sea ultimately winning through bribes to the government. Later that year, the government moved to divert more capital to South Sea shares by hampering investment opportunities for rival companies in what became known as the Bubble Act, and public confidence was shaken. In this edition of the Crisis Chronicles, we explore the rise and fall of the South Sea Company and offer a cautionary look at the current reach for yield.
A Rogue’s Guide to Repackaging Debt: Start with Insider Trading . . .
Two key events predate the South Sea Bubble. First, around 1710, the Sword Blade Bank offered to exchange unsecured government debt issued by army paymasters for Sword Blade shares. But it did so only after having secretly amassed large holdings of the debt, which traded at a deep discount given investor uncertainty that Britain could pay its debts. Knowing the price of the debt would rise with the announcement of the debt-to-shares exchange, the Sword Blade Bank made a significant profit on its debt holdings in what would today be called insider trading.
The second key event was the formation of the South Sea Company in 1711, for the purpose of rivaling the East India Company in trade. But a unique feature included in the formation of the company was the exchange of shares for government debt, no doubt influenced by the prior Sword Blade Bank deal; five of the directors of the South Sea Company were from the Sword Blade Bank.
And remember from our introduction to the Crisis Chronicles series that “lessons learned often last only a lifetime and are easily forgotten.” So, will the current reach for yield lead to ever more complex, leveraged investments and the next credit market bubble? Or will the lessons from the Great Recession last at least a lifetime? Tell us what you think.
It is heartening, and a great credit to the Bank, to know that the New York Fed harbors and encourages such scholarly senior officials and are taking advantage of what Lewis E. Lehrman, founder and chairman of the Lehrman Institute, consistently propounds as the one true guide for policymakers: the laboratory of human history.
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