Chapter 7: Saving and Investing

Personal Saving Rate
Defining Investments
Savings Accounts
Government Securities
Homeownership as an Investment
Securities and Commodities
Investment Options
Government Regulation of the Market System
Weaknesses in the Market System

If you would be wealthy, think of saving as well as of getting.

—Benjamin Franklin, The Way to Wealth (1779)

Saving and investing are two sides of the same coin. The purpose of saving is to put aside money for use in the future. Saved money can actually make money if it is put into a bank account that earns interest. This is basically a low-risk investment with a low rate of return, but it does preserve the money for the future. Investing is another matter. It means exchanging money for assets that may or may not go up in value over time. Investments that go up in value reap profits for the investor, and those profits can be modest or extravagant. Investments that go down in value are another story. Some or even all the original money invested is lost. Thus, investing entails risk, particularly in a market-driven economy where fluctuations in supply and demand determine the profitability of investments. At a macroeconomic level, the U.S. economy thrives on investing—it provides money for business growth and government expenses. From a microeconomic standpoint, Americans are urged to save and/or gainfully invest some of their earnings to ensure that they have a safety net in the event of a personal financial crisis and to sustain them after they retire.

Personal Saving Rate

The personal saving rate is a government-measured rate that tracks how much money Americans have available for saving and investing. It is calculated by the U.S. Department of Commerce's Bureau of Economic Analysis (BEA) using data from many sources on income, taxes, government revenues and expenses, and personal expenses. The rate is actually a ratio of two BEA measures: personal saving and disposable personal income (DPI). The DPI is defined as personal income (e.g., wages and salaries) minus tax and nontax payments made to the government. Personal saving is determined by subtracting personal outlays (which are 97% personal consumption expenditures) from DPI. Thus, personal saving is the money left over. This value is divided by the DPI to show what percentage of DPI is available for saving and investing.

Because the personal saving rate is based on so many other calculated variables, any small errors in the dependent variables will be exaggerated in the rate itself. In addition, the BEA excludes from its definition of income certain wealth components such as capital gains (which is an increase in the value of an asset). As a result, the agency admits that the personal saving rate gives an incomplete picture of household savings behavior. However, it is useful for tracking changes over time.

Table 7.1 shows the amounts and derivations of personal saving from 1959 to the third quarter of 2007. Personal saving was $56.7 billion in 2007, based on a seasonally adjusted annual rate calculated using data for the third quarter of 2007. Personal saving peaked in 1992 at $366 billion and then began to decline dramatically. Figure 7.1 shows the personal saving rate for the first quarter of 2000 to the first quarter of 2008. The rate is calculated by dividing personal saving by DPI. The rate was positive through the second quarter of 2005 and negative in the subsequent quarter. A negative amount of personal saving indicates that Americans spent more than their disposable income. From the fourth quarter of 2005 through the first quarter of 2008 the saving rate was positive, with the exception of the third quarter of 2006, when it was slightly less than zero.

Defining Investments

In the broadest sense, any money expenditure that returns a profit is considered an investment. Thus, the cost of a college education would be considered an investment, because it will likely increase earnings potential in the future. In this discussion, investments are limited to tangible

assets (such as cash or real estate) and intangible financial assets (such as stocks, bonds, and other securities).

Savings Accounts

Savings accounts are accounts held at financial institutions in which customers can deposit money for safe-keeping. Deposits up to $100,000 per customer are insured at most financial institutions by the Federal Deposit Insurance Corporation (FDIC), an independent government agency. FDIC insurance ensures depositors that their money will be repaid even if the financial institution goes out of business.

The Survey of Consumer Finances (SCF) is a survey conducted every three years by the Federal Reserve Board, the national bank of the United States, in cooperation with the Internal Revenue Service, to collect detailed financial information on American families. The most recent SCF was conducted in 2007; however, those results had not been published as of July 2008. Thus, this discussion relies on 2004 SCF data.

According to Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore of the Federal Reserve, in “Recent Changes in U.S. Family Finances: Evidence from the 2001 and 2004 Survey of Consumer Finances” (Federal Reserve Bulletin, February 2006), less than half (47.1%) of American families had a savings account in 2004.

Variations on savings accounts include money market deposit accounts (which allow limited withdrawals in some circumstances) and certificates of deposit (CDs). CDs are savings accounts in which money is placed for a predetermined amount of time, commonly one to five years, in exchange for payment of a set interest rate throughout that time period. There are penalties for early withdrawal of the money.

Government Securities

The government issues a variety of securities with the purpose of earning revenue. Local and state governments sell bonds to raise funds for public projects, such as road improvement or school construction. A bond is basically an IOU from the government that promises to pay back the borrowed amount plus interest at a specified future date (the maturity date). The federal government also sells bonds (called savings bonds) through the U.S. Department of Treasury.

Savings bonds are not marketable securities. They can only be sold or redeemed by the Department of Treasury. Treasury bills (T-bills) are short-term securities that mature within a few days or up to twenty-six weeks. The customer purchases a T-bill for less than its face value and then receives face value at maturity. For example, a customer might pay $90 upfront for a $100 T-bill. When the T-bill matures, the customer will receive the $100. T-bills can be bought and sold in other markets. Treasury notes (T-notes) have maturity periods lasting two, three, five, and ten years. They earn a fixed rate of

interest every six months. T-notes can be sold by the customer before the maturity date.

Figure 7.2 shows the annual percent yield between 1995 and 2008 on a ten-year T-note. The interest paid on the ten-year T-note decreased during the late 1990s, rebounded in 2000, and then declined through 2003. After rising for several years, the rate took another drop beginning in early 2007.

Homeownership as an Investment

One of the largest investments made by most Americans is the purchase of a home. Because real estate tends to appreciate in value, buying a home is considered a relatively low-risk investment. During the mid-1980s interest rates began a downward trend in response to rate cuts by the Federal Reserve. The result was a boom in home purchases and refinancings that lasted into the middle of the first decade of the 2000s. In 2005 the housing market began a sharp market downturn that had not subsided as of July 2008. Figure 7.3 shows the sales rate for newly built and existing single-family homes from 1997 through the spring of 2008. Annual sales of newly built homes peaked above 1.4 million units in 2005 and then plummeted to 530,000 units by March 2008. (Note that these are seasonally adjusted annual rates). Annual sales of existing homes exceeded six million units in 2005 and early 2006 before declining sharply. As of March 2008, annual sales were estimated at 4.3 million units.

Table 7.2 shows the vacancy rates for owner homes and rental units between 1995 and early 2008. The vacancy rate of owner homes was less than 2% through 2005, and then it began to rise. The homeowner vacancy rate for the first quarter of 2008 was 2.9%. In contrast, the rental vacancy rate soared to 10.4% in the early 2000s and remained high in the first quarter of 2008 by historical standards. Economists agree that high vacancy rates are generally an indicator of a sluggish economy.

The Housing Bubble Bursts

A housing bubble is a condition in which homes become overvalued due to overconfidence by exuberant investors. As described in Chapter 1, a stock market bubble in Internet-based companies grew and then burst in 2000, causing major losses for some investors. A bubble is only obvious after the fact, when investments suddenly plummet in value and it becomes apparent that they were overvalued.

Appreciating home prices and decreasing interest rates combined to make the housing market attractive to investors during the 1990s and early 2000s. Flipping is a practice in which a home is purchased as a short-term

investment, rather than for living purposes. During a housing boom homes can be bought and resold quickly for a handsome profit. Likewise, homeowners who want to move may wait for a boom to peak before selling or sell quickly and rent in anticipation of lower home prices after the bubble bursts. The gamble for all parties involved is the difficulty of predicting when a boom will end and prices will fall.

Cynthia Angell and Norman Williams of the FDIC conducted a study to quantify housing booms and busts that have occurred since 1978 and reported their findings in “U.S. Home Prices: Does Bust Always Follow Boom?” (February 10, 2005, http://www.fdic.gov/bank/analytical/fyi/2005/021005fyi.html). The researchers define a boom as occurring when inflation-adjusted home prices in an area increase by 30% or more during any three-year period. Using this criterion, Angell and Williams identify dozens of metropolitan areas around the country that have experienced temporary housing booms that could be described as unsustainable bubbles. Geographically, they were concentrated in California and the Northeast.

Housing Price Index

The Office of Federal Housing Enterprise Oversight (OFHEO) is a federal financial regulator. It was established

as an independent entity within the U.S. Department of Housing and Urban Development by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. The OFHEO House Price Index (HPI) provides an indicator of home appreciation (increase in home value) by measuring average price changes in repeat sales of the same properties over time.

In Decline in House Prices Accelerates in First Quarter (May 22, 2008, http://www.ofheo.gov/media/hpi/1q08hpi.pdf), the OFHEO explains that, nationwide, home prices appreciated dramatically during the late 1990s and early 2000s. (See Figure 7.4.) Appreciation peaked in 2005 and then plummeted. The HPI was actually negative from the third quarter of 2007 through the first quarter of 2008. The HPI decline of 1.7% in the first quarter of 2008 was the largest quarterly decrease recorded by OFHEO since the index began in 1991.

From 1997 through 2006 the OFHEO reports strong appreciation rates. (See Figure 7.5.) During 2004 and 2005 home prices appreciated by 8% to 9% per year. A definite turndown in the housing market is apparent between the first quarter of 2006 and the first quarter of 2007, when the HPI increased by only 3.2%. Between the first quarter of 2007 and the first quarter of 2008 home

prices fell by 3.1%. According to the OFHEO, the states with the sharpest depreciation levels for this period were:

• California—down 10.6%
• Nevada—down 10.3%
• Florida—down 8.1%
• Arizona—down 5.5%
• Michigan—down 3.1%

Nationwide, the OFHEO reports declines during the first quarter of 2008 in forty-three states.

Some analysts believe the OFHEO index values do not completely capture the seriousness of the housing slump, because the OFHEO only tracks conforming mortgages (i.e., mortgages that conform, or meet, loan limits set by the Federal Home Loan Mortgage Corporation [Freddie Mac] and the Federal National Mortgage Association [Fannie Mae]). Thus, the OFHEO does not track mortgages in the high-end of the market (e.g., greater than approximately $400,000).

Another index, the Standard & Poor's Case-Shiller HPI, does include high-end mortgages and is frequently reported in financial publications. Actually, dozens of indices are reported for different geographical regions. A national index tracks single-family home resales around the country and is reported quarterly. Standard & Poor's reports in the press release “National Trend of Home Price Declines Continued into the First Quarter of 2008 According to S&P/Case-Shiller Home Price Indices” (May 27, 2008, http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_052703.pdf) that the Case-Shiller HPI for the first quarter of 2008 was down 14.1%, compared to the first quarter of 2007. Since early 2006 the index has experienced a continuous quarterly decline in value.

Home Mortgages

The Federal Reserve compiles home mortgage data on a quarterly and annual basis. These values are published in tabular form in “L.218 Home Mortgages” as part of the Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States (http://www.federalreserve.gov/releases/z1/). The Federal Reserve only includes mortgages secured by one-to-four family properties, including owner-occupied condominium units. Mortgage types include first and second mortgages, home equity lines of credit,

mortgages held by households under seller-financing arrangements, and construction and land development loans associated with one-to-four family residences.

Table 7.3 lists outstanding mortgage amounts reported by the Federal Reserve as annual amounts from 2003 through 2005 and on a quarterly basis from 2006 and 2007. As of the end of the fourth quarter of 2007, there was more than $11.1 trillion in outstanding mortgages. The vast majority of this amount—$10.5 trillion, or 95% of the total—was devoted to the household sector. Another $586 billion in mortgages was attributed to nonfarm, noncorporate businesses. Just over $41 billion was devoted to nonfinancial corporate businesses.

Securities and Commodities

Securities markets (stocks, bonds, and mutual funds) and commodities markets (raw materials and foreign currencies and securities) in the United States are used by corporations to raise money for their business operations and by individuals and banks to build wealth and, in some cases, pay for retirement. These markets have fueled periods of astounding economic growth (called bull markets), but they have also been at the center of downturns (called bear markets) and disastrous economic crashes, creating the need for an extensive regulatory system. Despite regulations, however, the markets occasionally see high-profile scandals involving major figures in the business world.

Securities are financial assets that give holders ownership or creditor rights in a particular organization. The word usually refers to stocks (also sometimes called equities), but there are other types of securities that can be bought and sold on the open market, including bonds and mutual funds. Commodities are tangible products— usually raw materials—that are bought and sold in bulk, as well as financial instruments such as foreign currencies and securities of the U.S. and foreign governments. Commodities can refer either to the material itself or to a contract to buy the item in the future.

Stocks

To raise money to operate and expand a company, its owners will often sell part of the company. A company that wants to raise money this way must first organize itself as a legal corporation. At that time, it creates shares of stock, which are small units of ownership in the company. These shares of stock can then be sold to raise funds for the company. Those who own them are called shareholders in the company. They have the right to attend shareholder meetings, inspect corporate documents, and vote on certain matters that affect the company. Shareholders may also have preemptive rights, which means they are able to buy new shares before they are offered to the public so that existing shareholders can maintain their percentage of ownership in a company.

Not all corporations offer their shares for sale to the public. When a company chooses to do so, its first sale of shares is called an initial public offering (IPO). IPO stock is purchased by investors at a price set by the company. The money paid for each share of stock is then available to the company for its business operations. In return, shareholders can receive benefits in two forms: dividends and appreciation. Dividends are a portion of the company's profits distributed to shareholders. Not all companies that issue stock pay dividends. Those that do usually pay them every quarter (a quarter is three consecutive months of the year; there are four quarters in a fiscal year), and, even though each share of stock might earn only a few pennies in dividends, the total amounts to individual or institutional investors who hold large amounts of shares can be enormous. Appreciation is a gradual increase in the value of a share over time. If a corporation prospers, a shareholder can sell his or her share to someone else for a higher price than he or she originally paid for it. There is no guarantee that a stock will appreciate; however, it is quite possible that it will depreciate (decrease in value) over time.

TYPES OF SHAREHOLDERS. Corporations can offer different types of shares, called either common or preferred shares, with each type providing the shareholder a different set of rights. According to TD Ameritrade (2003, http://www.ameritradefinancial.com/educationv2/fhtml/stocksfunds/prevscom.fhtml), owners of common stock shares can be paid dividends in cash, property, or more stock. Cash dividends are investment earnings that are paid to the shareholder in the form of cash; they are taxed in the year in which they are paid out by a corporation to the shareholder. Property dividends are earnings usually paid in the form of the issuing company's products or services. Stock dividends are earnings paid in more shares of a company's stock. Even though cash dividends are the type of stock earning most often issued to common shareholders, a corporation may decide to stop paying dividends on a temporary basis if it is experiencing financial instability. Additionally, if a company files for bankruptcy, owners of common stock are the last to be paid, after all creditors and owners of preferred stock. Regardless, common stock shareholders do have certain rights within a company, such as the right to vote for board members and officers, which preferred stock owners do not have.

Preferred stock shareholders do earn guaranteed dividends, the values of which are set in advance and pay indefinitely unless the stock is retired or recalled. There are four different kinds of preferred stock. Cumulative preferred stock accumulates whether or not a company has suspended paying dividends, and the preferred shareholder is paid the accumulated earnings once the company begins paying dividends again. Cumulative preferred stock owners receive their dividends before common stock owners receive theirs. Noncumulative preferred stock does not accumulate over temporary dividend suspensions, and its owners do not receive dividend earnings before common stock shareholders. Participating preferred stocks allow shareholders to earn additional dividends when a company's profits exceed expectations. Convertible preferred stock can be changed into common stock if its owner wants to take advantage of common stock appreciation.

Even though both common and preferred shareholders can lose the money that they paid for their shares, as well as whatever money the shares may have earned since the initial purchase, they have what is called limited liability, meaning they cannot be held financially responsible for any lawsuits filed against the company. This limited liability is one of the most important characteristics of stock ownership. Without limited liability, people would not want to become part owners of the corporation, and the corporation would therefore have trouble raising the money it needs to operate and expand.

PRICING SHARES. When a corporation creates shares, it determines the price per share for the initial public offering. From then on the price of each share depends on the public's perception of how well the corporation is doing. The more profit a corporation makes, the higher the price per share is likely to be. The challenge for investors is that they cannot predict the future, and stock prices tend to fluctuate up and down over time. A variety of events can influence a stock's price, from the release of a popular new product to news that a company's chief executive officer is being investigated for fraud.

The market for stocks sold by shareholders to other shareholders is called the secondary stock market. It would be almost impossible for all shareholders to find buyers for their shares on their own when they choose to sell. To make it easier for shareholders to buy and sell shares, companies affiliate with a particular stock exchange that handles share transactions. The two most prominent exchanges in the United States are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). The NYSE and NASDAQ are themselves publicly traded companies. The United States also hosts the American Stock Exchange in New York City, the Boston Stock Exchange, the Philadelphia Stock Exchange, the Chicago Stock Exchange, and the Pacific Exchange in San Francisco, California. Additionally, there are stock exchanges in most countries throughout the world.

Bonds

Another way for a company to raise money is to borrow it. Companies can borrow from banks, just like individuals, but they can also borrow by issuing bonds, which are written promises to pay the bondholder back with interest. Bonds have a face value, called par, and that amount defines the amount of the debt.

A bond offers returns to holders in two ways. The organization that issued the bond pays interest to the holder, and the holder can redeem the bond after a certain period. That is, the holder can sell the bond back to the organization for its face value. The issuing organization will either make regular interest payments on the bond or initially sell the bond at a much lower price than the face value. After a certain amount of time (often many years), the holder can redeem the bond for face value.

Bonds differ from shares of stock in several important respects. First, any organization can issue bonds, whereas only corporations can issue stock. For that reason, unincorporated businesses and federal, state, and local governments use bonds to raise money. Second, bonds provide no ownership interest in the company. The organization's only obligation to the bondholder is to pay the debt and interest. Bonds are usually less risky for the purchaser than stocks, because the organization is legally obligated to pay the debt, whereas if a corporation has financial difficulties, it is not permitted to pay anything to shareholders until it has paid off its creditors. However, the rate of return on investment for stocks is generally higher than on bonds to compensate for the higher risk factor. Like stocks, though, bonds are traded by investors for prices that may be different from the par value. Investors who buy bonds are buying the right to receive the interest payments and to redeem the bond.

The price of a bond depends on a number of factors, including the organization's creditworthiness and the interest rate. Generally, the better the organization's credit rating, the higher the price of the bond. If the organization begins to have financial problems that could affect its ability to repay the bonds, the price of those bonds will go down. One of the best-known rating companies for bonds is Standard & Poor's, which rates issuing organizations on a scale ranging from AAA to D.

Bonds may be short term or long term. Long-term bonds are riskier than short-term bonds, and therefore tend to pay higher interest rates.

Mutual Funds

Most investors try to diversify investments; that is, they put money into a number of different types of investments, rather than just one or two (a person's total investments are called his or her portfolio). That way, even if one investment loses money, another may make enough profit to compensate for the loss.

However, for small investors it can be difficult to diversify. It takes time to evaluate different investments, and small investors may only be able to afford to buy one or two shares of each stock. Most brokers have a minimum purchase requirement that is higher than what the average investor can afford. Mutual funds were developed to solve such problems for small investors. In a mutual fund, the money of multiple investors is pooled and then invested in stocks, bonds, or both. The managers of the mutual fund then buy and sell the stocks and bonds on behalf of the investors. By combining their money, small investors are able to diversify.

Unlike the prices of stocks and bonds, the price of a mutual fund is determined by the fund manager, rather than by the open market. This price, called the net asset value, is based on the fund manager's estimation of the fund's value at a particular time. Mutual funds may be purchased either directly from the fund manager or through a broker or other intermediary. The latter is more expensive, because the investor will be required to pay fees. Mutual funds provide income to investors in two ways. First, if the mutual fund sells stocks or bonds at a profit or receives dividends or interest payments on bonds, these gains can be paid to investors as distributions. Second, the price of the mutual fund itself may go up, in which case investors can sell their mutual funds for more than they paid.

Some people are willing to take a fair amount of risk when they invest, hoping that they will make more money. Usually, the riskier the investment is, the higher the potential return on it is. Others would rather get a smaller return but know that their money is invested in a safer vehicle. Different types of mutual funds have been developed to meet the needs of these different types of investors. Mutual funds differ just as investors do in how much risk they want to take. Some mutual funds invest more conservatively than others. The safest type of mutual fund—and the one that pays the lowest interest—is a money-market fund, which invests in short-term bonds such as T-bills.

Commodities

The term commodity, in the narrow sense used here, means a contract to buy or sell something that will be available in the future. (In a broader sense, anything that can be bought or sold is a commodity.) These sorts of agreements are traded in commodities exchanges. Two important exchanges in the United States are the Chicago Board of Trade and the Kansas City Board of Trade.

There are two basic types of commodities. Futures are standardized contracts in which the seller promises to deliver a particular good to the buyer at a specified time in the future, at which point the buyer will pay the seller the price called for in the contract. Options on futures (which are usually simply called options) are more complicated. Depending on their exact terms, they establish the right of the buyer of the option to either buy or sell a futures contract for a specified price. Options that establish the right to buy a futures contract are call options. Those that establish the right to sell a futures contract are put options. In either case, the buyer of the option only has a limited time in which he or she can exercise his or her right, but the buyer is also free not to exercise the right at all.

The meaning of a commodities contract has changed over the years. Raw materials and agricultural commodities have been traded through commodities exchanges since the mid-nineteenth century. More recently, commodities markets have expanded to include trading in foreign currencies, U.S. and foreign government securities, and U.S. and foreign stock indexes.

Because contracts are made before the goods are actually available, commodities are by their very nature speculative. Buyers purchase commodities because they think their value may increase over time, whereas the sellers think their value may decrease. For example, the seller of a grain futures contract may believe there will be a surplus of grain that will drive down prices, whereas the buyer thinks a shortage of grain will drive up prices. It is the speculative nature of commodities that makes them interesting to investors. Even if they have no need for the goods that the commodities contracts represent, speculative investors can make a profit by buying the commodities contracts at low prices and then selling them to others when prices rise. Commodities respond differently than stocks and bonds to market forces such as inflation; therefore, they can be a valuable part of a diversified portfolio. However, they are riskier and more difficult to understand.

Investment Options

Thanks to retirement investment options including 401(k) plans (funds that workers can contribute to on a before-tax basis and that grow tax-free until the money is withdrawn), a large percentage of Americans are now stock market investors. Given that Social Security retirement benefits are relatively low compared to a person's career income, and that the long-term solvency (the state of having enough money to pay all debts) of Social Security continues to be in question, retirement funds are essential to the baby-boom and later generations as they approach retirement age.

Historically, stocks have appreciated faster than inflation has increased, allowing people to build greater wealth than if they attempted to save money in traditional accounts. Investments can also serve as collateral for certain loans. Therefore, even though Wall Street might seem far away, it provides small investors the opportunity to build wealth and prepare for retirement far more effectively than they otherwise could.

The stock market has also made it easier for employers to contribute to their employees' retirement funds. This is because many employers contribute company stock, instead of cash, to their employees' retirement accounts.

Retirement accounts are the most commonly held type of financial asset. Nearly half (49.7%) of all families surveyed in 2004 had a retirement account. (See Table 7.4.) Another 20.7% held stocks, 17.6% had savings bonds, and 1.8% had bonds of other types.

According to the Investment Company Institute (ICI), in 2008 Investment Company Fact Book (2008, http://www.icifactbook.org/pdf/2008_factbook.pdf), retirement assets were greater than $17.6 trillion in 2007, up 7% from 2006. The ICI notes that the largest types of retirement

assets were individual retirement accounts ($4.7 trillion) and employer-sponsored defined contribution plans ($4.5 trillion). Seventy-one percent of U.S. households reported in May 2007 that they had assets in individual retirement accounts and/or employer-sponsored retirement plans.

Government Regulation of the Market System

Prices of stocks, bonds, and commodities fluctuate naturally, which generally is not cause for concern. However, when fluctuations are created as a result of greed or corruption, or by the creation of artificial and unsustainable conditions, the results can be disastrous. Such was the case in 1929, when the stock market crashed and ushered in the period known as the Great Depression. The exact causes of the 1929 crash and the ensuing depression are complex and reach far beyond U.S. borders. However, certain conditions related to the U.S. stock market were significant contributors to the economic disaster. The federal government under President Franklin D. Roosevelt (1882–1945), who served from 1933 to 1945, passed a number of laws designed to prevent the sort of abuses of the market that led to the Great Depression, laws that form the basis for the modern market regulatory system.

An Unregulated System

At the time of the 1929 crash, the stock market was largely unregulated. In the months before the crash, there were signs that the system was beginning to collapse under its own weight, but the industrialists who owned most of the real wealth fed millions of dollars into the market to stabilize it. They were successful for a time, but at last the artificial conditions created through margin buying (the buying of many market shares at a deflated value) and wild speculation brought the whole system down. Most people lost all, or nearly all, of the money they had invested in the stock market.

Regulation of Securities

Beginning in 1933, Congress enacted a series of laws designed to regulate the securities markets. The Securities Act of 1933 (sometimes referred to as the Truth in Securities law) was a reaction against the events that led up to the stock market crash of 1929. Its purpose was relatively simple: to protect investors by ensuring that they receive full information on the securities offered for sale to the public, and to prohibit fraud in such sales. The Securities Act set up a system whereby most corporations that wanted to offer shares for sale to the public had to register their securities; the registration information was then made available to the public for review. The required registration forms (which are still in use today) contained information on the company's management and business structure and the securities it was offering for sale, as well as financial statements drafted by independent accountants. This system was intended to protect investors by making available any information they needed to make informed decisions about their investments, although the truth or accuracy of the information was not guaranteed.

With the passage of the Securities Exchange Act in 1934, Congress established the Securities and Exchange Commission (SEC), which regulates the entire U.S. securities industry. The SEC expanded the Securities Act of 1933 to require more stringent reporting of publicly traded companies and all other entities involved in securities transactions, including stockbrokers, dealers, transfer agents, and exchanges. Additionally, large companies with more than $10 million in assets and five hundred shareholders are required to file regular reports with the SEC detailing their finances and business dealings. The Securities Exchange Act of 1934 also explicitly outlawed illegal insider trading.

Additional legislation that regulates the securities industry includes:

• Public Utility Holding Company Act of 1935—this act oversees interstate holding companies that sell or provide gas and electric utilities.
• Trust Indenture Act of 1939—this act requires a trust indenture (a formal agreement between a bondholder and an issuer of bonds) when debt securities such as bonds are offered for public sale.
• Investment Company Act of 1940—this act requires investment and trading companies, such as those that handle mutual funds, to divulge their financial and management information to the public, as well as information about the funds they offer for sale.
• Investment Advisers Act of 1940 (amended in 1996)— when this act was originally passed, it required most investment advisers to register with the SEC and abide by laws designed to protect investors. In its amended form, the act applies only to advisers who manage at least $25 million in assets or work with a registered investment company.
• Sarbanes-Oxley Act of 2002—this act is the strongest legislation since the 1940s to impose reforms on the securities industry. Intended to combat fraud and encourage corporate accountability, it also established the Public Company Accounting Oversight Board. Under Sarbanes-Oxley, companies that trade in the U.S. markets must perform audits of their fraud-prevention and accounting procedures, as well as annual examinations by management of their internal controls. One of the most significant reforms instituted by Sarbanes-Oxley is the provision that bankrupt companies must compensate investors before paying creditors. This provision was largely the result of the WorldCom scandal.

The Commodities Futures Trading Commission

The trading of commodities futures and options in the United States is regulated by the Commodities Futures Trading Commission (CFTC). Established by Congress in 1974, the CFTC is responsible for ensuring integrity in the commodities markets. Like the securities markets, commodities exchanges are not immune to corruption in the form of fraud, misrepresentation, and price manipulation. The most recent update to the Commodities Exchange Act was the Commodity Futures Modernization Act of 2000.

In “About the CFTC” (May 6, 2008, http://www.cftc.gov/cftc/cftcabout.htm?from=home&page=aboutcftcleft), the CFTC notes that the sitting U.S. president appoints the five commissioners of the commission, who serve staggered five-year terms, as well as a chairman. Under the chairman's administration are the Office of the Inspector General, which is responsible for the internal audits of the CFTC; the Office of International Affairs, which handles the CFTC's involvement in the global markets; and the Office of External Affairs, which serves as the CFTC's media liaison. The CFTC has offices in all U.S. cities that have commodities exchanges: New York, Chicago, Kansas City, and Minneapolis.

Weaknesses in the Market System

Even with careful oversight, fraudulent activities can occur in the securities industry. Securities fraud and the ensuing scandals are devastating to investors and to the markets as a whole. There were many high-profile instances of accounting scandals and securities fraud in the early twenty-first century.

Illegal Insider Trading

Insider trading is the buying or selling of stock by someone who has information about the company that other stockholders do not have. Most often, it refers to directors, officers, or employees buying or selling their own company's stock. Insider trading alone is not illegal, but insiders must report their stock transactions to the SEC. Insider trading becomes illegal when it is unreported to the SEC and breaches a fiduciary duty to the corporation; that is, when it violates a duty to act in the corporation's best interests. Most often, this happens when someone in the company has confidential information and uses it as the basis for a stock transaction. For example, if a company officer knows that the company is going to file for bankruptcy the next day and sells the company's stock because he or she knows the stock price is going to plummet, the trading is illegal. The same goes for someone who gives the information to an outside stockholder so he or she can act on it.

The best-known case of illegal insider trading in the early twenty-first century involved the company ImClone Systems, the media mogul Martha Stewart (1941–), and the stockbroker Peter Bacanovic (1962–). The SEC alleged that Bacanovic passed confidential information to Stewart and that she sold her stock in ImClone because of that information. The SEC also accused Stewart and Bacanovic of trying to cover up the matter afterward by lying to federal investigators. The insider trading charge against Stewart was dropped, but she was convicted of lying to investigators and obstruction of justice. Bacanovic was convicted of most of the charges against him. Stewart entered prison to serve a five-month sentence in October 2004 and was released to house arrest in March 2005.

Overvaluing and Accounting Scandals

Overvaluing is the overstatement of income by companies with the assistance of their accountants to create an inflated impression of financial success among investors, thereby increasing the value of stock. In the early twenty-first century, Wall Street experienced many scandals concerning such accounting practices at major corporations. The most egregious and notorious breaches of regulations occurred at three companies: Enron, WorldCom, and Tyco (see Chapter 6). All three became targets of SEC investigations, with company executives brought up on criminal fraud charges and investors losing billions of dollars.