Securities and Commodities Markets

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chapter 4

Securities (stocks, bonds, and mutual funds) and commodities (raw materials and foreign currencies and securities) markets 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.


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. Shares of stock are bought and owned by shareholders, who have the right to attend shareholder meetings, inspect corporate documents, and vote on certain matters that affect the company. Shareholders also may 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, while each share of stock might earn only a few pennies for every share of stock owned, the amounts paid in dividends to large individual or institutional investors can be enormous. Appreciation is a gradual increase in the value of a share over time. If a corporation prospers then a shareholder can sell his share to someone else for a higher price than he originally paid for it. There is no guarantee that a stock will appreciate, however; it is quite possible it will depreciate (decrease in value) over time instead.

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 Ameritrade (, 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. Although cash dividends are the stock earning most often issued to common shareholders, a corporation may decide to stop paying dividends on a temporary basis if the company 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. Common stock shareholders, however, do have certain rights within a company, such as the right to vote for board members and officers, which preferred stock owners do not.

Preferred stock shareholders do earn guaranteed dividends, though, 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.

Although 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, of course, is that shareholders cannot predict the future, and stock prices have a tendency 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 CEO (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. In the United States the two most prominent exchanges are the New York Stock Exchange (NYSE) and the NASDAQ (originally known as the National Association of Securities Dealers Automated Quotations, but now called by its acronym). The NYSE and NASDAQ are themselves publicly traded companies. The United States also hosts the American Stock Exchange, Boston Stock Exchange, Chicago Stock Exchange, Pacific Exchange in San Francisco, and the Philadelphia Stock Exchange. Additionally, there are stock exchanges in most countries throughout the world.


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 of time. 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 very 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 impact 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 and 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, and therefore tend to pay higher interest rates. For investors, the safest type of bond is called a T-bill, which is a short-term bond issued by the U.S. Treasury. Investors are very unlikely to lose money on T-bills. As a result, the interest rate of T-bills is low, but investors know that their investment is safe.

Table 4.1 provides historical information on bond yields and 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.

For small investors, however, 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 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 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 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 developed to meet the needs of these different types of investors. (See Figure 4.1.) 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.


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 can exercise his right, but he is also free not to exercise the right at all.

The meaning of a commodities contract has been changing. Raw materials and agricultural commodities


Bond yields and interest rates, 1900–2002
[Percent per year. Annual averages of either daily or monthly figures, except as indicated]
YearU.S. Treasury securities 3 month bills (new issues)Corporate bonds (Moody's) AaaCorporate bonds (Moody's) BaaHigh grade municipal bonds (Standard & Poors)New home mortgage yieldsPrime rate charged by banksDiscount rate, Federal Reserve Bank of New YorkFederal funds rate
NA Not available.
source: "No. HS-39. Bond Yields and Interest Rates: 1900 to 2002," in Statistical Abstract of the United States: 2003, U.S. Census Bureau, (accessed January 4, 2005)
Highest value14.0314.1716.1111.5715.1418.8713.4216.38
Lowest value0.012.533.051.645.811.501.001.57

have been traded since the mid-nineteenth century. More recent years have seen commodities markets expand to include trading in foreign currencies, U.S. and foreign government securities, and U.S. and foreign stock indexes.

Since contracts are made before the goods are actually available, commodities are by their very nature speculative. Buyers purchase commodities because they think that their value may increase over time, while the sellers think their value may decrease. For example, the seller of a grain futures contract may believe that there will be a surplus of grain that will drive down prices, while the buyer thinks that a shortage of grain will drive prices up. 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 from 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.


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. As of 2001, 21.3% of Americans held stocks directly, 17.7% were invested in mutual funds, and 52.2% had retirement accounts (many of which include stocks, bonds, or mutual funds). (See Table 4.2.) Since Social Security retirement benefits are relatively low compared to a person's career income, and the long-term solvency of Social Security continues to be in question, retirement funds are essential to the baby-boom and later generations as they approach retirement age.


Types of assets held by families, 1995–2001
[Median value in thousands of constant 2001 dollars (18.0 represents $18,000). All dollar figures are adjusted to 2001 dollars using the "current methods" version of the consumer price index for all urban consumers published by U.S. Bureau of Labor Statistics. Families include one-person units.]
Age of family head and family incomeAny financial asset1Transaction accounts2Certificates of depositSavings bondsStocks3Mutual funds4Retirement accounts5Life insurance6Other managed7
1Includes other types of financial assets, not shown separately.
2Checking, savings, and money market deposit accounts, money market mutual funds, and call accounts at brokerages.
3Covers only those stocks that are directly held by families outside mutual funds, retirement accounts and other managed assets.
4Excludes money market mutual funds and funds held through retirement accounts or other managed assets.
5The tax-deferred retirement accounts consist of IRAs, Keogh accounts, and certain employer-sponsored accounts. Employer-sponsored accounts include 401(k), 403(b), and thrift saving accounts from current or past jobs; other current job plans from which loans or withdrawals can be made; and accounts from past jobs from which the family expects to receive the account balance in the future.
6Cash value.
7Includes personal annuities and trusts with an equity interest and managed investment accounts.
8Value in parentheses represent median income for that percentile group. Percentile: A value on a scale of zero to 100 that indicates the percent of a distribution that is equal to or below it. For example, a family with income in the 80th percentile has income equal to or better than 80 percent of all other families.
9Median value of financial asset for families holding such assets.
source: "No. 1167. Financial Assets Held by Families by Type of Asset: 1995 to 2001," in Banking, Finance, and Insurance, U.S. Census Bureau, 2003, (accessed January 4, 2005)
Percent of families owing asset
1995, total91.087.014.322.815.212.345.232.03.9
1998, total92.990.515.319.319.216.548.829.65.9
2001, total93.190.915.716.721.317.752.228.06.6
Under 35 years old89.286.06.312.717.411.545.115.02.1
35 to 44 years old93.390.79.822.621.617.561.427.03.1
45 to 54 years old94.492.
55 to 64 years old94.893.614.414.326.721.359.135.713.0
65 to 74 years old94.693.829.711.320.519.944.036.711.8
75 years old and over95.193.736.512.521.819.525.733.311.2
Percentiles of income:8
Less than 20 ($10,300)74.870.910.
20–39.9 ($24,400)93.089.414.711.011.29.533.324.73.3
40–59.9 ($39,900)98.396.117.414.116.415.752.825.65.4
60–79.9 ($64,800)99.698.816.024.426.220.675.735.78.5
80–89.9 ($98,700)99.899.718.330.337.029.083.738.610.7
90–100 ($302,700)99.799.222.029.760.648.888.341.816.7
Median value9
1995, total18.02.511.61.210.423.119.65.834.7
1998, total24.53.316.
2001, total28.
Under 35 years old6.
35 to 44 years old26.
45 to 54 years old45.74.612.
55 to 64 years old56.65.519.02.537.560.
65 to 74 years old51.
75 years old and over40.07.325.

Historically, stocks have appreciated faster than inflation has increased, allowing people to build wealth with less sacrifice than if they attempted to save money in traditional accounts. Investments can also serve as collateral for certain loans. Therefore, although 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 stocks, instead of cash, to their employees' retirement accounts. Table 4.3 shows the percentage of company stock in the retirement plans of some major companies.

Despite the inherent risks of investing, approximately ninety-two million Americans, or one out of every three people, were mutual fund shareholders as of June 2004. This is the most common type of investment, according to the Investment Company Institute (ICI). The data collected by ICI indicates that the average shareholder is middleaged, married, and college-educated. In December 2003 49% of 401(k) plan assets were held in mutual funds. As investors age, they tend to shift their 401(k) funds to more secure investments. The ICI reported that investors in their sixties had approximately 35% of their investment in equity (stock) funds.

According to the U.S. Census Bureau in Net Worth and Asset Ownership of Households: 1998 and 2000 (May 2003), African-Americans and Hispanics held a smaller percentage of their financial assets in stocks and mutual funds compared to non-Hispanic whites. In 2000 African-American households typically held only 4% of their net worth in stocks and mutual fund shares, while Hispanic households held 8.3% of their net worth, and non-Hispanic white households held 16.2% of their net worth in stocks and mutual funds. The percentage of net worth held in 401(k) and other thrift savings plans was 6.7% for African-American households, 9.6% for non-Hispanic white households, and 9.9% for Hispanic households.

As crucial as investments are for building wealth and preparing for retirement, though, they are not foolproof by any means. Some economists argue that the securities market is a relatively "perfect" market—that is, the market behaves in a predictable way in part because investors are all on equal footing—but there is no such thing as a perfect market.


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 market crashed and ushered in the period known as the Great Depression, which lasted until the mid-1940s. An economic depression is more serious and longer lasting than a recession. The average lifespan of a depression is usually about ten years, stretching across two or three full business cycles, or normal sequences of growth and decline in the economy. Depressions are associated with very high levels of unemployment and a slow-down or complete stop of inflation. Recessions are similar, but not to the same degree or for the same length of time; they usually last just two to three years. The exact causes of the stock market crash of 1929 and the ensuing depression are very complex and reach far beyond U.S. borders. But certain conditions related to the American stock market were significant contributors to the economic disaster. The federal government under President Franklin D. Roosevelt (1933–45) passed a number of laws designed to prevent the sort of abuses of the market that led to the Great Depression, laws which form the basis for the modern market regulatory system.

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


Employer stock in selected retirement plans, 2001
Company nameCompany stock as a percentage of defined contribution plan's assets:Does company have a defined benefit plan?
source: Patrick J. Purcell, "Table 1. Employer Stock in Selected Retirement Plans," in The Enron Bankruptcy and Employer Stock in Retirement Plans, Congressional Research Service, Library of Congress, March 11, 2002, (accessed January 4,2005)
Procter & Gamble91.5%No
Abbott Laboratories80.0%Yes
General Electric77.4%Yes
William Wrigley, Jr.75.0%Yes
Home Depot72.0%No
BB&T (Branch Banking & Trust)69.6%Yes
Texas Instruments69.0%Yes
Duke Energy67.9%Yes
Reliant Energy64.5%Yes
Southern Company62.8%Yes
Household International61.4%Yes
TXU (Texas Utilities)56.3%Yes
Dell Computer53.4%No
Ford Motor Company50.2%Yes

they had invested in the stock market. Ultimately, about 50% of the new securities that were offered in the 1920s became worthless.

When the stock market crashed, the economy crashed with it. The banking industry, which depends on consumer confidence to stay in business, was devastated. The economy did not fully recover until World War II, when government spending increased dramatically to support the war effort. Farmers, who were affected by the crashes of both the stock and commodities markets, filed for bankruptcy in record numbers during the Depression, with 6,000 filing in 1933 alone, according to Farmer Bankruptcies and Farm Exits in the United States, 1899–2002, a report from the Economic Research Service of the U.S. Department of Agriculture.

Table 4.1 shows the dramatic drop in the return on three-month Treasury bills from 1929 through 1941. Prior to the Great Depression, the return was 4.42%, but it declined to a low of 0.01% in 1940. Similarly, Table 4.4 shows a drop in stock prices from 1929, with an average share closing price of $26.02 in the Standard and Poor's Composite, to 1934's average closing share price of $9.84. Figure 4.2 shows the drop in the gross national product from $105 billion in 1929 to only $55 billion in 1933.


Stock yields and prices, 1900–2002
Stock pricesCommon stock yields (percent) Standard and Poor's1
Dow-Jones & Co., Inc.
Standard and Poor's 500 composite (1941-43=10)1,2NYSE common stock index (Dec. 31, 1965=100)3NASDAQ composite3 (Feb. 5, 1971=100)Industrial (30 stocks)
YearComposite (Dec. 31, 1965=50)3Year-end close (30 stocks)Yearly highYearly lowTransportation3 (20 stocks)Utility3 (15 stocks)Dividend price ratio4Earnings price ratio5
NA Not available.
1Source: U.S. Council of Economic Advisors, Economic Report of the President, annual.
2Annual average of daily closing prices. The S&P 500 composite index represents the 500 largest publicly traded companies.
3As of end of December.
4Aggregate cash dividends (based on latest known annual rate) divided by aggregate market value based on Wednesday closing prices. Averages of monthly figures.
5Averages of quarterly ratios which are ratio of earnings (after taxes) for four quarters ending with particular quarter to price index for last day of that quarter.
source: "No. HS-38. Stock Prices and Yields: 1900 to 2002," in Statistical Abstract of the United States: 2003, U.S. Census Bureau, (accessed January 4, 2005)
Highest value1,427.22656.94,069.33,317.411,497.111,908.59,571.43,256.5412.27.4315.20
Lowest value6.1521.132.7199.754.656.840.6130.968.81.152.92


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 had 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 with the Securities and Exchange Commission (SEC); the registration information was then made available to the public for review. The required registration forms—still in use today—that contain information on the company's management and business structure and the securities it is offering for sale, as well as financial statements drafted by independent accountants. This system is intended to protect investors by making available any information they may need to make informed decisions about their investments, although the SEC does not guarantee the truth or accuracy of the information.

With the passage of the Securities Exchange Act in 1934 Congress established the Securities and Exchange Commission (SEC), which regulates the entire American 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 (described below).

Additional legislation that regulates the securities industry includes:

  • Public Utility Holding Company Act. Passed in 1935, this Act oversees interstate holding companies that sell or provide electric and gas utilities.
  • Trust Indenture Act of 1939. A trust indenture is a formal agreement between a bondholder and an issuer of bonds. The Trust Indenture Act requires this agreement 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 Advisors Act of 1940; amended in 1996. When this Act was originally passed, it required most investment advisors to register with the SEC and abide by laws designed to protect investors. In its amended form the Act applies only to larger advisors 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 (PCAOB). 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 (described below).

The Commodities Futures Trading Commission

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 forms of fraud, misrepresentation, and price manipulation. The most recent update to the Commodities Exchange Act was the Commodity Futures Modernization Act of 2000.

The sitting U.S. president appoints the five commissioners of the CFTC, who serve staggered five-year terms, as well as a chairman ( Under the CFTC chairman's administration are the Office of the Inspector General, which is responsible for 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.


Even with careful oversight, fraudulent activities are common in the securities industry. In 2004 the SEC received 8,722 complaints from investors, up from 6,384 in 2003 (2003 figures are lower in part because data on e-mail and fax spam was not kept that year). The number of complaints of misrepresentation of company disclosures decreased 30.22% from 2003 to 2004; complaints involving theft of funds or securities also went down, from 787 to 660 (16.14%). Other decreases were in unauthorized transactions (down 0.87%, from 809 to 802), bankruptcy or issuer reorganization (down 0.97%, from 722 to 715), and excessive or unnecessary administrative fees (down 7.87%, from 788 to 726). On the other hand, complaints of account transfers went up 6.77%, from 739 to 789; complaints of problems with redemption, liquidation, or closing increased 46.57%, from 481 to 705; complaints of advance fee fraud increased 99.53%, from 633 to 1,263; and complaints of manipulation of securities, prices, or markets went up 314.80%, from 419 to 1,738. According to the SEC (, these huge increases are due largely to the explosion of stock market scams such as fraudulent telephone, fax, and e-mail messages alleging possession of a "hot stock tip," and to "phishing" scams in which victims are asked to disclose personal financial information to criminals pretending to be legitimate businesses.

Securities fraud and the ensuing scandals are devastating to investors and to the markets as a whole. There were numerous high-profile instances of accounting scandals and securities fraud in the early twenty-first century; in 2002 alone, the SEC filed 163 enforcement actions, up from 103 in 2000. (See Table 4.5.)

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 by itself 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


SEC enforcement efforts and outcomes, 2000–02
SEC activityFY 2000FY 2001FY 2002
source: "Table 2.1. SEC Enforcement Efforts and Outcomes 2000–2002," in Economic Report of the President, U.S. Government Printing Office, February 2003, (accessed January 4,2005)
Financial fraud and issuer reporting actions filed103112163
Officer and director bars sought3851126
Temporary restraining orders filed333148
Asset freezes564363
Trading suspensions11211
Subpoena enforcement actions81519
Disgorgement ordered (millions)$463$530$1,328
Penalties ordered (millions)$44$56$116

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 tomorrow, the trading is illegal. The same goes for someone who leaks the information to an outside stockholder.

The best-known case of illegal insider trading in the early twenty-first century involved the company ImClone Systems, Inc., along with Martha Stewart and her stockbroker, Peter Bacanovic. 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 also 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 in order 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 numerous scandals concerning such accounting practices at major corporations. According to Penelope Patsuris of ("The Corporate Scandal Sheet,", August 26, 2002), inflated figures were reported for such companies as Halliburton, Kmart, Xerox, Merck, Adelphia Communications, Bristol-Meyers Squibb, and AOL Time Warner. The most egregious and notorious breaches of regulations occurred at three companies: Enron, WorldCom, and Tyco. All three became targets of SEC investigations,


with company executives brought up on criminal fraud charges and investors losing billions of dollars.

enron. Based in Houston, Texas, Enron was an international broker of commodities such as natural gas, water, coal, and steel. In August 2000 Enron's stock rose to an all-time high of $90 a share. But the company was incurring more and more debt because its contracts outstripped its ability to deliver. To hide its liabilities, Enron created a web of partnerships; the idea was to transfer debt so it would not show on the company's books. Enron's accounting firm, Arthur Andersen, helped the company hide its debts and shredded key documents. With debts transferred to other entities, Arthur Andersen and Enron could overstate the value of the company, and its stock continued to perform well.

Enron had to pay the debts either with cash or with stock, and doing so would create a huge loss that the company could not hide. Enron vice president Sherron Watkins discovered the accounting discrepancy in the summer of 2001, becoming the key whistleblower when she sent a memo about the problem to CEO Kenneth Lay. In October 2001 Enron announced part of the loss—$638 million in the third quarter of 2001, with a loss in shareholder equity of $1.2 billion—and its stock price plummeted. The company announced that it was being investigated by the SEC for possible conflicts of interest with its many partnerships. In November 2001 Enron stock dropped to less than a dollar a share, and in December the company filed for bankruptcy. (See Figure 4.3.) Four thousand employees were laid off at that time.

Shortly before announcing the income overstatement, Enron executives took two additional steps. First, some of them sold their stock so they could get their money out before the stock lost all its value. Second, the company imposed a freeze on employee sales of the stock shares in their 401(k) plans. So when the news broke and employees tried to sell their stock to save what they could of their savings funds, they found that they were stuck with worthless stock in a bankrupt company. According to the labor union American Federation of Labor-Congress of Industrial Organizations (AFL-CIO) ("What Went Wrong at Enron?", accessed March 9, 2005), more than 6,100 people lost their jobs, along with their health care, retirement funds, and, in many cases, life savings. While investors both in and outside the company lost tens of billions of dollar, Enron wrote $55 million in bonus checks for company executives the day before it declared bankruptcy.

In February 2005 a U.S. district judge in Houston set January 17, 2006, as the start date of the criminal trial of Enron founder Kenneth Lay, former CEO Jeffrey Skilling, and former accounting officer Richard Causey. Skilling and Causey were charged with thirty counts of fraud, conspiracy, and insider trading; Lay was charged with seven counts of fraud and conspiracy. According to the HoustonChronicle ("Enron: Houston Chronicle Special Report,", accessed March 9, 2005), as of March 2005 criminal charges were brought against thirty-three former Enron executives and others affiliated with the company, with six jury convictions, fifteen guilty pleas entered, three British bankers fighting extradition to the United States to stand trial, one acquittal, and five others awaiting trial in addition to Lay, Skilling, and Causey. Enron's accounting firm, Arthur Andersen, was appealing its conviction on obstruction of justice charges; the appeals case was due to be heard in April 2005.

worldcom. News broke in March 2002 that WorldCom—the second-largest long-distance telephone company in the United States and the world's largest Internet provider—had overstated its accounts by $3.8 billion. In November 1997 WorldCom had merged with MCI (the largest company merger up to that point in U.S. history) to form MCI WorldCom. Two years later, in October 1999, the company announced plans to merge with another long-distance carrier, Sprint, which would have made it the largest telecommunications company in the United States. But before the deal could go through, the United States Justice Department raised questions about the three merged companies creating a monopoly in the telecommunications industry, so the deal was dropped. In 2000 MCI WorldCom went back to calling itself WorldCom.

In June 2002 the SEC began investigating WorldCom's accounting practices. A month later the company filed for bankruptcy—the largest such filing in U.S. history to date. The stock held by investors was worthless, and former employees who lost their jobs, pensions, benefits, and severance pay formed the ex-WorldCom Employees Assistance Fund and joined with the AFL-CIO to retrieve some of what they had lost. In June 2002 WorldCom owed four thousand of its former employees $36 million (Nomi Prins, "Whose Jobs? Our Jobs!" Dollars and Sense: The Magazine of Economic Justice, no. 246, March-April 2003, By 2003 WorldCom was believed to have inflated its accounts by more than $11 billion. In May 2003 the company—which changed its name to MCI after filing for bankruptcy—agreed to settle the SEC's fraud suit against it by paying $500 million in fines, which would be paid to shareholders, according to the guidelines of the Sarbanes-Oxley Act (Stephen Labaton, "MCI Agrees to Pay $500 Million in Fraud Case," New York Times, May 20, 2003,

The suit was one of the largest the SEC had ever filed, but it still did not address the activities of WorldCom's executives, many of whom were themselves accused of fraud. Former WorldCom chief financial officer (CFO) Scott D. Sullivan and chief executive officer (CEO) Bernard J. Ebbers in particular were believed to have been involved in the accounting scam. Both were indicted on charges of conspiracy and securities fraud. Sullivan, who faced twenty-five years in prison, agreed to testify against Ebbers, who was accused of inflating WorldCom's accounts to cover his own $350 million in loans that he owed to Bank of America ("Prosecutor's Attack Former WorldCom Chief's Claims of Ignorance," March 2, 2005, On March 15, 2005, Ebbers was convicted of all nine charges against him. He could be sentenced to a maximum of eighty-five years in prison but was expected to appeal the conviction.

tyco. Tyco International, Ltd., originally based in Bermuda but later located in West Windsor, New Jersey, is a holding company whose many branches produce fire and security systems, electronic components, medical supplies, and pharmaceuticals. In 2002 a series of scandals erupted, centered around Tyco's CEO, L. Dennis Kozlowski, and its CFO, Mark Swartz. Kozlowski was forced to resign in June, soon to be followed by Swartz. By the end of the year Tyco was suing its former executives in connection with $600 million in loans, salary, and fringe benefits they allegedly took from the company without board approval. The government indicted the men for grand larceny and securities fraud, among other criminal charges.

Kozlowski and Swartz were originally brought to trial in New York State Supreme Court in September 2003, accused of taking $170 million in "unauthorized compensation" from the company and "covertly" selling $430 million in stock at artificially inflated prices (Dan Ackman, "Dennis the Menace on Trial Today,", September 29, 2003). Particularly at issue during the trial was Kozlowski's extravagant lifestyle. Prosecutors told of Kozlowski throwing his wife a $2.1 million birthday party paid for in part by Tyco, living in a $19 million Manhattan duplex bought for him by the company, and purchasing a $6,000 shower curtain, all while Tyco investors lost millions because of his stock manipulations. Kozlowski and Swartz were among the first company heads indicted on criminal charges after the fall of Enron. Their case, however, was declared a mistrial in April 2004, when a juror, suspected of communicating with defense attorneys, was named in the media and subsequently received threatening letters and phone calls. Kozlowski and Swartz went on trial for a second time in January 2005. Each could receive twenty-five years in prison if convicted on the most serious of the charges against them.

Special Favors and Special Timing of Mutual Funds

Mutual funds reduce risk to investors by diversifying investments, and until recently they were considered by


many to be a good choice for investors who wanted a relatively high return with less risk than a straight stock investment. Indeed, the percentage of American households that owned mutual funds grew from 5.7% in 1980 to 44% in 1998. (See Figure 4.4.) As waves of scandals began to hit the securities industry, it seemed wiser than ever to invest in mutual funds.

In late 2003, however, questions began to arise about the business practices of mutual fund companies. As government agencies began investigating, they discovered illegal transactions in more than a dozen mutual fund companies, including well-known and trusted firms like Bank of America and Charles Schwab. The investigations centered primarily on two types of transactions: market timing and late trading. These two types of transactions are illegal; however, executives at mutual fund companies allowed preferred clients to make these trades. Furthermore, company executives engaged in these transactions themselves.

Market timing is the practice of making rapid "in and out" trades to manipulate prices. Mutual funds are valued only one time each day. Market timing allows the investor to take advantage of "stale" information to buy low and sell high. Late trading also depends on the once-a-day pricing system for mutual funds. The market closes at 4:00 p.m. By trading at 4:01, the trader gets the benefit of the next day's higher price. These practices are problematic because the illegal trader gets a windfall that corresponds exactly to a loss suffered by other investors who did not have the same advantage. By March 2005 some of the indicted companies had agreed to pay settlements to the government. Other cases are still unfolding.


The price of a given security or commodity is largely a function of its potential profit and risk; and, theoretically at least, the relationships among price, risk, and expected profit behave in fairly predictable ways. For example, bond prices will tend to rise when overall interest rates go down. But there are much less predictable forces at work as well. Changes in consumer or investor confidence, resulting from a major news event, can have a significant impact on the markets, even though such things might not seem to have much to do with stock prices.

Historical data from the Bureau of Labor Statistics indicates that changes in the market can result in higher unemployment, lower housing starts, or changes in price indices. A drop in household income may, in turn, be associated with certain social problems, such as crime. The U.S. Department of Justice, for example, has identified a correlation between income and intimate-partner violence.

Terrorism's Effect on Market Activity

Terrorism, or the threat of it, has historically affected the economies of both the countries involved and other


Stock prices and yields, by index, 1990–2002
source: "No. 1204. Stock Prices and Yields: 1990 to 2002," in Banking, Finance, and Insurance, U.S. Census Bureau, 2003, (accessed January 4, 2005)
Member firmsNumber5,8275,4265,4515,5535,5975,5925,4825,5795,4995,392
Branch officesNumber24,45757,10558,11960,15162,96670,75280,03582,12688,16891,473
Companies listedNumber4,1324,9025,1125,5565,4875,0684,8294,7344,1093,663
Shares tradedBillion33.474.4101.2138.1163.9202.0272.6442.8471.2441.7
Average daily volumeMillion1322954015446488021,0821,7571,9071,753
Value of shares tradedBillion4521,4492,3983,3024,4825,75911,01320,39510,9357,254

world markets. Although economists debate the degree to which people, businesses, and global markets are impacted, economic activity does slow down and consumer confidence drops immediately following a terrorist threat or attack. At the very least, a terrorist attack can damage a city or country's infrastructure (transportation and communication systems) so that financial activity is forced to stop temporarily. After the attacks on the World Trade Center in Manhattan and the Pentagon in Washington, D.C., on September 11, 2001, the telephone system, public transportation, and other essential services in New York City were shut down, forcing the closure of the New York Stock Exchange, NASDAQ, and the American Stock Exchange for six days. When communication was restored and the markets reopened, stock prices suffered a sharp decline.

But the 9/11 attacks had even broader global economic consequences. Note the drop in the average daily volume on the NASDAQ from 1,907 million to 1,753 million from 2001 to 2002 in Table 4.6—even though the previous ten years had shown a steady and sometimes dramatic increase. The New York Journal News reported on September 10, 2002 that one year after the 9/11 tragedy the travel and tourism industry was still hurting economically from the reduced number of people traveling by air in general and specifically traveling to New York City. Yet there was no substantial impact seen on Wall Street one year after the attack.

Another major impact of terrorism is that more businesses put higher security measures into place, which has broad implications for an economy. The production of security-related items such as metal detectors increases, but some economists see this as an unproductive use of resources because the people hired to monitor security systems are not manufacturing any products. In addition, since the cost of the extra security measures is passed from the businesses to the consumer, increases in prices can negatively affect production and sales.

After the 9/11 attacks, the House Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises and the Committee on Financial Services held hearings to investigate ways to increase the security and stability of U.S. financial markets in the event of another terrorist attack. According to the SEC's "Testimony Concerning Recovery and Renewal: Protecting the Capital Markets against Terrorism Post-9/11" (Robert L.D. Colby,, February 12, 2003), both the securities industry and the regulatory commissions instituted policies to safeguard the markets as a result of the 9/11 terrorist attacks. The industry's efforts included creating a better data backup system, improving crisis management procedures, and, especially, developing a more advanced telecommunications system. The SEC reported that it had worked with the Federal Reserve Board and the Office of the Comptroller of the Currency to identify practices that would minimize disruption of the market system during a large-scale disaster such as a terrorist attack. SEC also worked closely with the Financial and Banking Information Infrastructure Committee (FBIIC), the Federal Emergency Management Agency (FEMA), and New York City and State agencies to improve the overall safety of the securities markets.

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