How To Lose (Forever)

Don’t bother learning from the financial mistakes of the past

Paul Delaroche’s “The Young Martyr”

“There are two ways to be fooled. One is to believe what isn’t true; the other is to refuse to believe what is true.” — Soren Kierkegaard

Extraordinary Delusions

We’re all human, and unfortunately, with that thorny crown, we’re prone to errors and miscalculations. In fact, the beauty of having a mental capacity greater than other species is that we learn from these mistakes — usually.

But one issue seems to rear its ugly head repeatedly without people taking the time to reflect on why: speculative financial bubbles.

In early recorded history there is little to be found regarding financial bubbles, but what’s obvious is people were still prone to taking on insurmountable debt. In Ancient Greece, this problem was “solved” by enslavement of debtors. Genghis Khan “solved” it by executing anyone who declared bankruptcy three times. These solutions were… extreme.

Kings and Lords were known to have primitive versions of what we’d now term “auditors.” These royal subjects were the “ears” for the King or Lord (audare is latin for “to listen”), and if discrepancies were discovered it would be bad news for whoever gave false information. But this, too, failed to adhere to the standards we hold companies to today.

Modern bankruptcy law didn’t take effect for centuries after this. Between the 1600s–1840s corporations were companies endowed with a royal decree providing them with a monopoly over a sector in a given area. Prime examples of these included the East India Company and the Hudson’s Bay Company, both established in the 1600s, retaining shipping and trading rights over great swaths of territory. These corporations were still, nonetheless, prone to financial failures.

One of the first written works to touch on the subject of speculative financial bubbles was Extraordinary Popular Delusions and the Madness of Crowds by the Scottish author Charles Mackay. The book is a summary of previous financial bubbles: Tulipomania, the South Sea Bubble, and the Mississippi Scheme. While describing the ruinous ventures, Mackay also recounts astounding feats of greed and stupidity being perpetrated by laymen.

The South Sea Company

While many are familiar with the 1630s Tulipomania as the first example of a speculative bubble, the real fun began in the later 1600s. Over the course of several decades, England familiarized itself with the concept of banknotes — promissory notes giving the bearer a right to a certain asset when they chose to collect it. These notes gained in popularity over time, not only because they were less difficult to carry around and use (as opposed to heavy gold and silver coinage), but also because banks were realizing they could loan out more promissory notes than the assets backing them, so long as everyone didn’t attempt to redeem at once.

This proved to be important, less so for the everyday citizenry, but instead, for the government and monarchs of England, which were in the midst of running up unprecedented levels of debt due to the ongoing War of Spanish Succession and The Great Northern War. In an attempt to mitigate this debt, England did multiple state lotteries — notably, with a bank other than The Bank of England (in this case, the “Hollow Sword Blade Company,” which was founded as a rapier manufacturer and moved into banking) due to the fact that the BoE wasn’t offering good interest rates. The lotteries, while successful, failed to decrease the debt, and so a new solution was determined.

A Bubble is Born

A cessation to hostilities with the Spanish Crown (the war would end in 1713) would bring with it a slew of opportunities: the Americas would be opened up for trade, the Spanish would agree to allow English shipping to its colonies, and money previously allocated on military expenditures could be utilized elsewhere.

The South Sea Company was born under the guise that there was unfathomable money to be made in South America and a consolidation of government debt into a single entity would be a win-win for the government (which would be able to pay off its debt later to investors through shipping and trade) and citizens (who wanted government bonds because they were relatively stable, had a chance of increasing in value, and were easier to utilize than metal coinage). The initial contracts of the South Sea Company sold £100 shares for £55 to insiders — including, but not limited to, politicians, bankers, board members, and founders.

Unfortunately, it didn’t take long for this concept to turn sour: by 1718 England was at war once again, and the disproportionately positive outlook for the South Sea Company was in the midst of disintegrating. There would be no trade, there would be no boom, and now the government would need to figure out how to fund both a massive war and pay back its creditors.

And that’s when it all begins to get very funky, going from a simple poorly executed idea to an atrocious, gravity-defying, catastrophic trainwreck (if you want the TL; DR, skip the images below):

While the complexity of this is real and most laymen in the 1700s (and perhaps today) wouldn’t be able to make heads or tails of it, what it essentially amounted to was The South Sea Company issuing more stock, taking on more debt, and still continuing not to have any profitable business model, while simultaneously receiving an endorsement from the government and having its share price increase significantly.

The Real Bubble is the Friends We Make Along the Way

While a bill officially signing off on terms worked its way through Parliament, the price for South Sea Company stock continued a gradual climb to above £300. This level of increase wasn’t due to the government contract alone: board members took to the streets to spread spurious rumors that would’ve benefitted the company, such as an upcoming peace treaty with Spain, a plethora of silver and gold to be had in Mexico, and that every hundred pounds invested would return hundreds more. It worked incredibly well.

It seemed at that time as if the whole nation had turned stock-jobbers. Exchange Alley was every day blocked up by crowds… Every body came to purchase stock. ‘Every fool aspired to be a knave.’ — Charles Mackay

Soon, other bubble companies were being formed with the express intent and purpose of defrauding investors, which actually proved to be a boon for the South Seas Company. As the government sought to squash these frauds, the Bubble Act of 1720 proposed that a Royal decree would be required for any corporate formations. Nearly a hundred companies were declared illegal, including a company, “For a grand American fishery,” and one, “For the transmutation of quicksilver (mercury) into malleable fine metal”.

After these alternative investments were declared illegal, money flooded back into the South Seas Company at an even faster pace, and no sooner than the stock price had doubled, it’d doubled again, hovering between £500-£800. At this point, a rush of investors attempted to sell shares, but were met with a liquidity crisis. There were no buyers.

On this news, board directors requested that their employees go to Exchange Alley and put in buy orders. This stemmed the bleeding, and even rose the share price further, quickly approaching £1,000. However, this miracle was rescinded with great vengeance.

The Bubble Pops

The South Sea Bubble, a Scene in ‘Change Alley in 1720 by Edward Matthew Ward

Subscribers here by thousands float/And jostle one another down/Each paddling in his leaky boat/And here they fish for gold and drown. — Jonathan Swift

Politicians and the BoD of the South Seas Company knew that prices this high were unsustainable, so they attempted to pass a series of resolutions to ease the fears of investors. These resolutions failed.

With a flood of sellers, the price plummeted like a rocket to earth, going from £800 to roughly £150 in a matter of 30 days. Many were ruined. Millions of pounds (inflation-adjusted, billions of pounds) evaporated overnight. Politicians lost their jobs and the BoD of the South Seas Company was ridiculed and admonished.

But none of this addressed a growing problem transpiring across Europe as a whole:

Men were no longer satisfied with the slow but sure profits of industry. The hope of boundless wealth for the morrow made them heedless and extravagant for to-day… Nobody seemed to to imagine that the nation itself was as culpable as the South Sea company. Nobody blamed the credulity and avarice of the people… — Charles Mackay

Sometimes History Doesn’t Rhyme, It Repeats

A few of my readers may be too young to recall the dot-com bubble in the late 1990s, nearly 300 years after the South Sea Bubble. During this boom, companies, which often amounted to nothing more than a website, would list on OTCM (pink sheet exchanges) or NASDAQ, and would almost instantly be bought up. P/E ratios were absurd, especially considering many of these companies did absolutely nothing or were hemorrhaging cash.

As a child during this period my mother allowed me to trade stocks — we got lucky and I bought some winners — but even as a kid I witnessed incomprehensible financial feats. An example of one such feat was snowball dot com, which was valued at ~$1.50/share but was purchased for a value of ~$12.50/share (it went on to become IGN). There was no explaining what was transpiring, but everyone wanted in.

Brokerage firms were happy to oblige:

Everyone and their grandmother was trading and giving advice. And they were all wrong. From 2000–2001, the NASDAQ Composite Index lost almost 80% of its value. Daytraders were ruined.

Of course, it happened again in ’08 — this time derivatives traders and house flippers were hit the hardest. In the lead up to the burst, everyone was exclaiming how important it was to buy real estate, like, RIGHT NOW. They were wrong again.

Hence, the concept behind this article is a simple one: you don’t have to be a financial genius or work in FinTech to understand when a bubble is approaching. Been seeing endless talk about RobinHood? E-toro commercials? Did your Uber driver try to talk stocks? There exists a world filled with clues that have been verifiable since the first iterations of bubbles began. In this world, greed rules, logic fails, and, “this time it’s different,” isn’t a joke, it’s a slogan ignorant investors live by. Don’t be fooled: anything from tulips to derivatives of derivatives of real estate can enter bubbles, and the exit always hurts more.

Pay attention, and stay skeptical, friends.



Fraud. Fraud everywhere.

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