Black Swan and the South Sea Bubble:

Black Swan is a metaphor that describes rare events that come as a surprise and have a major impact on the conduct of human affairs.These events are often inappropriately rationalized after the fact with the benefit of hindsight. The theory was developed by Nicholas Taleb and applies, amongst other things, “to the psychological biases that make people blind to the massive role of major events in historical affairs.”

To bring this into focus a Black Swan has been used by pundits to describe  the ‘Housing Bubble’ in 2008, a very rare event, and the subsequent credit crisis, a not so rare event.

Comparisons are often somewhat erroneous but in this case I do not think the pundits have it right. We live in an age where the media is the message and this requires that every event have a catchy name or ‘buzz’ word that can be used in sound bites and social media. It is this need to name an event that turns the process of rationalization on its ear. As we shall see there was in reality very little new or different with the events surrounding the collapse of credit markets in 2008.

Credit crises’ or financial panics have been around for a very long time. They happen whenever an event occurs that destroys the knife-edge confidence that users have in specie (paper money)  Because we rely on government institutions to protect the underlying value of paper as our medium of exchange they are nearly always found wanting, when things go wrong.

To illustrate my point I would like to relate the story of another great credit crisis that took place two hundred years ago in England. when the concept of specie was still very new, as was the concept of a Central Bank.

What came to be known historically as the Great South Sea Bubble got under way in the very early years of the 18th century when the Bank of England tried to manipulate the balance sheet of the nation by transferring war debts to a private company.

Historians are at odds as to who came up with the idea but suspicion  falls on a few enterprising entrepreneurs, likely members a Merchant Bank. They wanted a Charter from Parliament to trade as a monopoly with the Spice Islands of South East Asia.

This was the way things were done in era of colonization. The Hudson Bay Company had a monopoly to trade firs from Canada as had the East India Company for almost everything imaginable from the whole continent of India. The founders of The South Sea Company expected to get very rich from any such franchise so were willing to pay huge bribes to members of parliament to get what they wanted. But the concept lacked political reality, so the idea was hatched for the new company to accept war debts of 50 million pounds as additional compensation for the Crown.

The founders got their way and the Charter was granted  against the wishes of the appointed Directors of The Bank of England. The Bank feared the new company would usurp their powers to control the money supply  and within two years hostilities commenced.

The order of battle was strange indeed. The Bank bid up the price of South Debt, that now included the War  Debt, in the mistaken belief that the prospect of reduced yields would make the investment  less acceptable to the thousands of punters who had flocked to get a piece of the action. The result was the opposite and the price of the South Sea shares quickly spun out of control increasing by over a hundred times.

As the price of the South Sea shares rose speculators jumped in and formed all kinds of other dummy companies, one offs,  supposedly linked in some fashion with the monopoly. They formed companies to ‘Make Salt Water Fresh’ to ‘Manufacture Square Cannon Balls’ and most audacious of all to ‘Carry on an Undertaking of Great Advantage. The capital raised served  only  to enrich the founders and feed the insatiable bubble.

The Government run by Britain’s first Prime Minister Robert Walpole,  finally became alarmed at the monster of their creation and clamped down on the speculators by tightening credit. By so doing  the omniscient powers trampled on those it was trying to help  and caused untold misery to irate constituents.  The  predictable result was the Government take over of the affairs of South Sea and the transfer all of the companies’ debts  and many others to the National Debt.

Applying the theory of Black Swan to this troubled tale yields fascinating comparison to the Housing Bubble and bust of 2008.

It all started with a seemingly wonderful idea promulgated by then President Clinton and the feel good Democrats that every person in the United States should be able to afford to own a house. It did not matter that income levels of the bottom twenty-five percent of the population were not enough to cover mortgage payments. Rather two appointed bodies, the US Treasury and the Federal Reserve Bank, would see to it that credit restrictions would not stand in the way of a new form of security, the Sub-Prime Mortgage that would make it all possible.  A good political strategy but not a winning economic  one since  bankers and other lenders would be able to see the obvious.

It would take some bright young sparks,  on Wall Street to figure out how to make a silk purse out of a sow’s ear by combining lots of sub-prime loans into a fund and, with the compliance of the rating Agencies, reclassifying the end product as  a Triple A Credit.

The grand ruse was a boon for the thousands of sales people who would earn good commissions by selling what were really junk bonds dressed up as the most secure credit available. Soon the easy credit spread to the Mortgage Brokers who, like their cousins in the Merchant Banks, did not let real facts get in the way of a successful credit application.

The rest, as they say, is history. A whole new industry sprung up,just like the one in the South Sea Bubble. As the products packaged and sold became more and more obtuse warning flags were ignored by the Federal Reserve who believed, mistakenly, that common sense would prevail and rising interest rates would correct the problem.   Finally Goldman Sachs had the unmitigated cheek to sell a product that bet against the house, and would only make money if the credit ruse was exposed. It would a hedge fund owner of this product that would expose the real risks involved to the buyers of the Mortgaged Backed Securities and the Merchant Banks that had packaged and sold them.

When Lehman Brothers failed the party was over and credit froze all over the globe. The first to the rescue  were the two institutions that had made the  whole mess possible, the US Treasury and the Federal Reserve Bank. Using the tools available to them the bought back, albeit at a discount, the ‘troubled assets’  the Mortgage Backed Securities, and charged the whole thing to the National Debt. Just as the British Government had done with the South Sea Company two hundred years before.

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