The British pension funds’ sudden vulnerability to an interest rate blip two weeks ago due to their misguided derivatives games showed that financiers make the same mistakes, decade after decade. While a few financial techniques are new, the errors are not; indeed they can be traced back to the era when modern finance was being created, in Britain in 1693-1720. Those wishing to learn how finance really works should take a course in the financial history of that era, when it was all invented for the first time, and the vulnerabilities were discovered by trial and error. The errors at least appear to be immortal.
The era of modern finance in England began in 1693, when William III’s Whig government needed to raise more finance for the Nine Years War than taxation would yield – they had already doubled taxation with a Land Tax, falling primarily on their Tory political opponents, but it was not enough.
There was a good example available, about which information was easy to come by since it related to William III’s home country of the Netherlands. Eighty years earlier, before it had achieved full independence from Spain, the Netherlands had faced a similar problem, which it had solved by selling long-term redeemable bonds and single-life annuities. Initially, the bonds had yielded around 8%, but over time that yield had descended, to 4% by 1640, where it remained for the remainder of the century.
From experience, the Dutch bankers discovered that simple long-term bonds were more liquid than annuities, because they were easier to value and hence traded in a liquid market, allowing buyers who later needed liquidity to sell their investment at a fair price. With this liquidity, and with the Dutch currency stable, investors would buy large amounts of these bonds at a low yield, even though the Netherlands remained subject to wars, invasions and even deliberate flooding throughout the remainder of the 17th century.
The English financiers did not follow this simple and effective example, however, and to understand why you need to know one of the basic principles of finance: the people controlling the market have their own incentives, which may lead to financial structures that are sub-optimal for the economy as a whole.
In England at this time, the Whig government was allied with the “monied interest” in the City of London, a cosmopolitan group including Dutch, Huguenot and a few Jewish financiers as well as the larger London trading houses. The Tory opposition primarily represented the “landed interest” of country squires as well as businessmen and other voters outside the London metropolis. With the easily available sources of financial support for long-term financings allied to the Whigs (and to William III’s regime in general) it was natural to make the financings as profitable as possible to that group. So that is what they did.
The first financing chosen was a tontine, in which the last survivor of the purchasing group ended up getting all the annual payments. This was a structure impossible to value; it also incentivized some seriously dodgy behavior among the holders, arranging unexplained accidents for each other to increase their payout – in the unpoliced society of the 1690s, where the homicide rate in London was roughly ten times today’s level, this was a serious risk.
When the tontines failed to sell, the government replaced them with annuities paying an extortionate rate of 14% per annum, giving an all-in cost of 12%, three times the Netherlands’ level for a country with a larger, more diversified economy and far less debt. The profits for investors on this deal were sufficient to set up a new bank, the Million Bank, which invested in the various overpriced government issues and remained in existence until 1796.
The following year, the Whig financiers were even more creative, inventing the SPAC – Special Purpose Acquisition Company. Their shell company was issued £1.2 million of debt at a stonking 8% interest rate, in return for a unique banking charter, by which it would become the largest bank and potentially a central bank. The Whiggish “monied interest” investors in this deal profited twice, from the 8% interest on the debt, which was sufficient to establish a very substantial banking operation, and from the earnings on the SPAC itself – christened the “Bank of England,” of which the management consisted entirely of Whig party supporters.
Two years later the Tories, who without controlling the government had established a small majority in the House of Commons at the 1695 election, tried to set up a competitor to the Bank of England, a Land Bank, whose business would primarily be the financing of mortgage loans to the country gentry, their principal base of support. The Land Bank, which aimed to raise £2 million of 7% debt, undercutting the Bank of England, was an abject failure, because the Whigs altered the official money value of the gold guinea and instituted a recoinage of the nation’s silver. Since the Land Bank subscriptions had to be made in cash, the lack of cash resulting from these Whig shenanigans prevented any subscriptions arriving – and the Bank of England cooperated by issuing short-term Exchequer Bills to its “monied interest” supporters, thus draining any cash that they might have wanted to invest in the new Land Bank. As on innumerable occasions in the future, the regulators were able to prevent the success of a promising new venture that might have competed with their vested interest.
The Bank of England now had too much short-term government debt, so it got its Ministerial friends to allow it to increase its capital by “ingraftment” buying £1 million of the debt with a new subscription of shares from its supporters, in return for a full monopoly on banking, an extension of its charter to 1711 and total exemption from all taxes. Economically, this would have been the most expensive of all the 1690s Whig financings, since it established a single monopoly Whig bank; fortunately the monopoly was poorly enforced. Enforcement was strengthened in 1708, in which year legislation was passed forbidding the establishment of any bank with more than six partners, atomizing the banking system until 1826 (which eventually, after local “Country banks” were set up after 1750, became a very useful mechanism to finance the small-scale enterprise of the incipient Industrial Revolution.)
In 1698, the Whigs raised another £2 million of 8% debt, in a market much improved by the Treaty of Ryswick having ended the war, by forming a Whig New East India Company, thus violating the charter of the century-old East India Company. The two companies competed vigorously for a decade, ensuring that neither was profitable, until in 1708 a merger of the two was accompanied by yet another £3.2 million of expensive debt lent by the merged company.
By 1700, a capital market had been set up, but at an appalling annual cost of 8.8% on annuities that had mostly been extended to 99 years. The following decade saw a more mixed political system – the Whig Junto had been forced out of office in 1699 – and the following War of the Spanish Succession was financed by Sidney Godolphin, a moderate Tory, mostly with 99-year annuities at an interest rate of 6.25%, still considerably more than the Netherlands but a more reasonable level nonetheless.
In 1710, a further financial crisis occurred. The Bank of England, by now fully in charge of the money markets, did not like the year’s political trends, by which Godolphin was being forced out and replaced by a Tory government. It therefore dried up the money markets, forcing a financial crisis but not preventing Queen Anne from installing Robert Harley as chief minister and the country from delivering a thumping Tory majority at the 1710 election. Now the Tories were in power, they too could use the SPAC mechanism; they did so through creating the South Sea Company, which acquired no less than £9.2 million of short-term government debt and swapped it for South Sea shares, supposed to become hugely profitable once a peace treaty had been signed through slave trading with the Spanish colonies.
The South Sea Company has become notorious to us through its crash a decade later but was no more unsound than the Bank of England. It had been set up by an unofficial bank (trading outside the Bank of England monopoly) the Hollow Sword Blade Company. The Sword Blade has also acquired a gamey reputation and was to meet a sticky end in the South Sea crash, but in the interim it performed an enormously important service for posterity in 1715 by providing about £20,000 of venture capital divided into 80 shares to “The Proprietors of the Invention for Raising Water by Fire” – the patent owner and marketer of Thomas Newcomen’s steam engine, orders for which were taken at the Sword Blade Coffee House. “The Proprietors” was modestly profitable through dividends to its shareholders by the expiry of the patent in 1733; more important, it had by then installed 110 Newcomen engines – more than twice the number installed in France in 1816, 83 years later.
The final South Sea Scheme was an attempt to swap all the ludicrously expensive debt remaining from the 1689-1713 wars into South Sea shares, which would pay only 5% dividends and could be sold at a premium, thus eliminating the expensive annuities running to 1792. Archibald Hutcheson essentially invented modern securities analysis to show that South Sea shares were overpriced at 200; they later rose to 1,000 and most of the expensive debt was converted into them. By this means, Britain’s debt service costs were reduced by about a third, at the cost of economic stagnation for several decades. However, careful administration over the next 30 years by Robert Walpole and Henry Pelham did enable the government to convert the debt in 1751 into the famous 3% Consols, thus finally achieving a financing cost lower than the Netherlands.
The century after 1720 saw a few banking crises but almost no financing innovation in Britain – probably why entrepreneurs were able to concentrate on the real economy and produce the Industrial Revolution. But the early years of 1693-1720 saw immense innovation, a gross rip-off of the Tory squires by the Whiggish “monied interest” – and pretty well all the financing techniques we have grown to dislike today. Regrettably the final lesson, that eventually excessive financial innovation will end in a massive financial crash and economic stagnation, has still to be learned.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)