Friday, February 01, 2013

Cotton Bond Bubble

A fascinating story, both a history and a modern caution.

...on Jan. 29, 1863, the Confederate Congress secretly authorized the Paris-based bankers at Erlanger et Cie. – which rivaled Rothschild for European royalty connections – to underwrite $15 million of Confederate bonds, denominated in British pounds or French francs.

But unlike ordinary bonds backed only by the faith and credit of the issuing country, at the option of the holder an Erlanger certificate could be converted into a receipt for a pre-specified quantity of cotton. Furthermore, the conversion rate was fixed at 12 cents a pound, regardless of the commodity’s market price, at the time about 48 cents. On top of that, the bonds paid a handsome 7 percent annual interest rate.

Put another way, a buyer of a £1,000 bond could convert it into 80 500-pound bales of cotton worth almost £4,000. If the price of cotton continued to rise, the underlying bond’s conversion-value would climb in lockstep. European investors flocked to the bonds, including the future British prime ministers William Gladstone and Lord Cecil.

But like any too-good-to-be-true investment, there was a catch: the cotton was located in the Confederacy. Upon conversion, Confederate authorities were obligated only to deliver the bales to a point within “ten miles of a navigable river or railhead,” where the new owner must arrange transport to the final destination.

ATSRTWT

Nod to JR, who asks:  "What would have happened in the war if they had followed Benjamin's way to sell cotton future instead of the banker's model?"
 

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