“The nation then too late will find
Computing all their cost and trouble
Directors’ promises but wind
South Sea at best a mighty bubble.”
-Jonathan Swift
The above quote was from Jonathan Swift’s The Bubbler’s Medley. It is perhaps the first written record of the term “bubble” being used to describe speculation and investor exuberance run wild.
Swift was describing the rise and fall of the South Sea Company, a public-private partnership that formed in 1711 to help reduce Britain’s national debt. And like most public-partnerships, it was rife with tomfoolery…
You see, the British government and South Sea Company brass had a pretty plum deal set up: in exchange for a complete monopoly of trade to Spain and — more importantly — all of its new colonies in South America, South Sea Company would float the government a loan to cover all of the debts that piled up during the War of Spanish Succession.
It seemed like a good deal: South Sea Company would have crucial rights to the burgeoning trade with a fertile new market and the government could rest easy knowing its debt was taken care of. However, the deal was shortsighted, and hinged on the outcome of the war itself. But instead of a trade monopoly after the war, Spain was granted sovereignty over all of those colonies — severely hampering the South Sea Company’s ability to cash in on its “monopoly.”
In fact, the company didn’t even start trade expeditions until 1717… so it had some serious catching up to do if it wanted to cash in on the sweetheart deal…
So it did what any shrewd business would do: it made yet another deal with the government: this time it convinced the government to convert some of the country’s debt into South Sea Company shares. This enriched the executives of the company while leaving the government — and individual investors — holding worthless scraps of paper.
Sound familiar?
It’s a hell of a lot like the Federal Reserve’s bailout of Wall Street…
Much like South Sea Company floating shares to cover the debt, the Fed loaned interest-free money to Wall Street, which it took and returned to the Fed to reap the interest payments. Wall Street has been reaping record gains from the Fed program while the Fed’s balance sheet hit a record $4.5 trillion in Treasuries and mortgage-backed securities.
This has led to huge distortions in the market, causing stocks to become overvalued while the debt keeps piling up.
It has masked the rather tepid growth of the companies trading at record highs…
It has painted over the stagnant wages of the employees working for those companies…
It has all but ignored the fact that while Wall Street rakes in the cash hand over fist, there has never been such a big gulf between main street and Wall Street…
Simply put, the whole program has turned into a Fed-fueled bubble in equity prices.
Like most government programs, once you start them, it becomes a Pandora’s Box. You can’t just stuff it back into the box and expect things to chug along like nothing has changed. And the longer the charge goes on, the tougher it is to close that box and return to “business as usual.”
That’s how ponzi schemes work. You have to keep chasing the dragon until everything goes up in smoke.
And when it does, there will be a hefty price to pay…
That price will only truly be seen once interest rates rise and the Fed is forced to cover its losses.
From the Wall Street Journal:
The Fed currently pays banks an interest rate of 0.25% a year on their reserves, and these reserves are the funding source for its purchases of Treasurys and mortgage bonds. When the Fed buys a bond, it pays for it with an IOU called excess reserves. It’s a liability of the Fed and an asset of the bank. Beginning in 2013, the Fed built systems that would replace some of its bank funding with lower-rate collateralized repo borrowing—akin to replacing a personal loan with an adjustable-rate mortgage.
That adjustable rate is the issue here: when interest rates rise, and the Fed is liable for funding those payments, it will essentially start operating in the red, owing millions in interest payments. This would be the first time the Fed posts losses, and it will not be pretty.
As we told you last week, ex-Fed official and QE architect Andrew Huszar points to those excess reserves as the canary in the coal mine.
How will they raise interest rates? Because the Fed funds rate as a tool really doesn’t work in an environment in which you have almost $2.5 trillion worth of excess reserves in the U.S. banking system.
So the Fed really is in uncharted territory in terms of how it deals with its balance sheet when it actually decides to stop buying. I think those are massively important questions and have huge implications for the Fed and how it actually tries to step away from the market, if it tries to step away from supporting the market.
So, like the South Sea Company, the Fed would go hat in hand to the government to bail them out!
That, my friends, is what keeps me up at night. Imagine what a complete loss of confidence in the Fed would do to stock market prices.
Like the South Sea bubble, we’ll be the last to know when that bubble bursts. In the South Sea bubble, the company and the government continued to blow smoke to investors until it finally exploded. The company began spinning yarns about how much treasure was awaiting in its South American riches. This is akin to the whimsical tales of today’s stock market.
“It’s just going to keep going up!”
“The best is yet to come!”
“Don’t sell now, you’ll be leaving a fortune on the table!”
So what happened to South Sea Company investors?
The stock ran from £550 in 1820, then almost doubled to a whopping £1050 in the throes of the investor frenzy. Did investors get wise and finally sell off? Of course not…
They held on for that last gasp of profits.
By the end of August, the stock fell to under £800. By September shares of the South Sea Company had tanked to £175…
These things happen quick. Take a lesson from history, and make sure you don’t wait around until the Fed bubble explodes in your face…
Take a page from legendary investor Sir John Templeton’s book. He correctly warned that “the four most dangerous words in investing are ‘This time it’s different’.”
