In the 1700s groups of brokers in Philadelphia, Pennsylvania, and New York City began to meet in parks and coffeehouses to buy and sell securities. In open auctions, traders called out names of companies and numbers of shares available. Shares went to the highest bidders. After the American Revolution (1775-1783) the number of securities traded increased dramatically. Brokers decided to organize in order to handle the growing volume. In 1800 the Philadelphia Board of Brokers drew up regulations and a constitution and set up central offices where trading could take place. The organization they created, the Philadelphia Stock Exchange, is the oldest exchange in the United States. In 1817 brokers in New York formed the New York Stock and Exchange Board (renamed the New York Stock Exchange [NYSE] in 1863).
As the United States grew and prospered during the 19th century, many more companies began to issue stocks and bonds. More people began to invest, and dozens of exchanges were formed across the country. Some of these are still in existence, but many others were short-lived. For example, the California gold rush of 1849 gave birth to a number of small exchanges where the public could buy shares in the new mining companies. As the gold rush subsided, these companies went out of business and the exchanges closed.
During the second half of the 19th century, New York City emerged as the primary financial center of the United States. The NYSE became the most successful exchange. Its members concentrated on trading the securities of the largest corporations. At that time, stocks of smaller companies were traded by brokers on the streets of downtown New York. In 1908 these brokers formed an organization called the New York Curb Agency, which became known as the American Stock Exchange in 1953.
During the 1920s millions of Americans began to purchase stocks for the first time. Many new investors entered the stock market with borrowed money. Stock prices rose steadily as inflated market demand outpaced increases in the value of the real assets of these businesses as well as their profits. Investors eventually realized that a large imbalance existed between stock prices and the real assets available to back them up, including profits, and decided to sell. On October 29, 1929, great numbers of people tried to sell their stocks all at once. Prices tumbled so drastically on the NYSE and other exchanges that the event became known as the crash of 1929. Millions of investors lost their savings in the crash, and many found themselves deeply in debt because they could not repay the money they had borrowed to buy stocks.
During the years immediately following the crash, most investors refused to put any more money in stocks. Without the flow of new funds, many businesses failed, and others laid off many workers because they could not afford to pay them. The lack of investment funds contributed to the Great Depression of the 1930s, an economic crisis that left one of every four American workers unemployed and resulted in widespread poverty.
Investors lost faith in the stock markets partly because of unfair practices and a lack of strict rules in the exchanges before and during the 1920s. Large investors were able to cheat small investors because few laws existed to forbid these practices. For the laws that did exist there was little in the way of enforcement. Recognizing that regulation was insufficient, the U.S. Congress passed the Securities Act of 1933. This act regulated the issuing of new securities. It mandated registration for all securities to be sold and required that a prospectus be prepared providing detailed information about each security to be issued.
Further protections came in 1945 when the U.S. Federal Reserve Board established that investors who seek a loan to finance the purchase of securities must pay a margin, or percentage, of the actual market price. Margin can be considered a down payment. The difference between the dollar value of the margin and the total price of the securities being purchased represents a loan from the broker to the investor. Investors pay margin to brokers, either in cash or by using other securities. This margin protects brokers from excessive losses. Before the Great Depression, investors had often borrowed heavily to make trades. These trades had very low margin requirements. With the stock market crashing investors were forced to sell securities at a price that was below the price they had paid. So when brokers tried to recover the money investors owed them, investors were unable to meet their obligations. Brokers, therefore, lost large sums of money on their loans.
From 1945 to the 1980s investors were required to make initial margin deposits for securities they wished to trade. The National Association of Securities Dealers (NASD) and the NYSE subsequently established their own minimum margin maintenance requirements. For the NYSE, the requirement is that investors must keep 25 percent or more of the market value of the securities in which they are trading in a margin account. Also, for certain stocks—especially those that trade heavily, often, and for widely varying amounts—the exchange may increase margin requirements. Investors must keep their margin accounts current, meeting the requirements, or else brokers may sell off their securities. Brokerage firms also have their own margin maintenance requirements for their clients. The requirements of firms are often higher than those of the exchanges. Overall, the government, exchanges, and brokerage firms have worked to protect the exchange system from excessive borrowing. However, in the late 1980s exchanges established new markets for stock index futures, and these markets had relatively low margin requirements.
In addition, by the 1970s it was clear that the NYSE, then the world’s largest stock exchange, in many ways did not perform the theoretical function of an exchange, to help facilitate the efficiency of trading. The NYSE tightly controlled its members with fixed commission rates and limited floor access. Nonmembers were required to trade only through member firms and to pay commissions. The exchange also rarely permitted members to trade in other regional exchanges or in the OTC market. Also, many NYSE firms increasingly traded in blocks of 10,000 shares or more. Taking advantage of loopholes in exchange regulations, firms often privately arranged these block trades. This created an essentially exclusive, limited-access market.
In the 1970s the Securities and Exchange Commission (SEC), Congress, and other government and private institutions were instrumental in establishing further regulations on stock exchanges. In 1972 the SEC developed a Consolidated Tape System, which provides trading information to investors from all exchanges and the OTC market. In 1975 Congress created the National Market System, which provides that prices of stocks and bonds from all exchanges be available simultaneously at each exchange. This encouraged competition among exchanges. A particular provision of this system also required that all commissions be competitively negotiated rather than fixed. In response to this provision, many discount brokerage firms opened. Discount brokers provide less financial advice to investors and therefore can charge lower commission fees than were available under the fixed-fee system. Ultimately, the enforced competition among exchanges has opened them to smaller investors who want to trade without paying for, or being limited by, various exclusive exchange privileges.
Reforms were also initiated in futures trading. The Commodities Futures Trading Commission (CFTC) was created in 1974 in response to the growth in futures trading and the start of several new futures markets. The general purpose of the CFTC is to ensure that prices in futures markets are free from manipulation and that the futures markets remain financially sound.
Although the overall value of the U.S. stock market has increased substantially since 1946, occasional downturns have occurred during recent decades. In 1987 the stock market experienced a brief, but major crash, marked by a more than 20 percent decline, over one day’s trading, in the Standard & Poor’s index of stock prices. (An index is an average of the stock prices of a selected group of companies.) Markets in other countries have experienced periods of severe decline as well. The market in Tokyo, for instance, plummeted over a period from the end of 1989 to late 1990. The Nikkei index of the TSE declined almost 50 percent during that period. Even with reforms instituted by the Japanese government, the TSE had failed to recover by 2002.
Economists linked the 1987 U.S. crash to the use by traders of new markets for low-margin stock index futures. Exchanges had opened these markets earlier in the decade in response to increased margin requirements on securities trading. Later in the decade traders began to sell their securities on the new futures markets when stock prices dropped. After the government released pessimistic economic forecasts in October 1987, traders rushed to sell their stocks on the futures markets with low margin backing. After the crash, the government established new rules for higher margin requirements across markets, including futures trading.
The 1987 crash also led to the institution of so-called circuit breakers on the NYSE. A circuit breaker is a temporary suspension of trading when prices fall by a particular amount. Beginning in 1998, the price declines necessary to trigger a circuit breaker were expressed in percentage terms. In one example of a circuit breaker, a 10-percent fall in the Dow Jones Industrial Average (DJIA) by 2 pm Eastern Standard Time (EST) would halt trading for one hour.
The period from 1990 to early 2000 saw a significant rise in stock prices. The growth resulted in the longest period of average increases in stock prices in the history of the United States. The market value of the outstanding shares of domestically issued stock rose from about $3.5 trillion to approximately $20 trillion. But then stock prices began to decline. By the middle of 2002 the market value of the outstanding shares of domestically issued stock stood at about $13.3 trillion.
The earlier period of rising stock prices, from 1990 to the first part of 2000, was known as a bull market. The bull market was linked to the strong national economy. A continued expansion of production and employment made investors optimistic about business profits and increased the demand for securities. This growth in demand was especially true for technology companies. In the latter half of the bull market the dot.com phenomenon developed. Small startup companies specializing in sales on the Internet began to issue stock. The prices of these stocks rose rapidly with strong demand, based on the belief that this new way of doing business would generate enormous profits.
The end of the bull market in 2000 and the beginning of a bear market (period of declining stock prices) was marked by several factors. One was the end of the national economic expansion with a decline in production and a rise in unemployment. Another was the end of the dot.com phenomenon when investors recognized that it was going to be much more difficult than originally forecast for these companies to become profitable. In 2001 the September 11 attacks by terrorists on the World Trade Center and the Pentagon also had predictable negative consequences for securities markets.
A fourth factor associated with the bear market involved a series of revelations regarding the accuracy of financial statements issued by corporations and the integrity of the independent public accounting firms that audit these financial statements. The best known of these cases involved the Enron Corporation and the Arthur Andersen LLP accounting firm. Enron, an energy company that traded in derivatives, engaged in a series of money-losing partnership transactions that were not reflected in its financial statements. Arthur Andersen, one of the nation’s largest accounting firms and Enron’s auditor, overlooked these questionable accounting practices, providing credibility to Enron’s misleading financial statements. The losses were finally revealed in the fall of 2001 when Enron officials admitted that the company’s net worth had been overstated by more than $1 billion. With the revelations the price of Enron stock fell from $83 per share in December 2000 to less than $1 per share in December 2001. Arthur Andersen was convicted of obstruction of justice charges in June 2002 in connection with its Enron activities. The loss of its reputation as an independent auditor was even more telling, causing Arthur Andersen to discontinue much of its auditing activity. At the same time that the Enron scandal was being reported, similar problems with financial statements were reported at a number of other companies including WorldCom, Inc. and Global Crossing.
The accounting fraud uncovered at WorldCom proved to be the largest in U.S. history. The company overstated its earnings by $11 billion, and its subsequent bankruptcy cost investors an estimated $200 billion. The United States Department of Justice brought criminal charges against WorldCom’s former chief financial officer, and the SEC filed civil lawsuits against four former WorldCom executives.
One result of these revelations of accounting and financial irregularities was the passage of the Accounting Reform and Investor Protection Act of 2002, often referred to as the Sarbanes-Oxley Act of 2002 for the legislators who sponsored it. The legislation sought to improve the accuracy of financial statements and to ensure full disclosure of information in these statements. It also created an oversight board for accounting practices, strengthened the independence of public accounting firms in their auditing activities, increased corporate responsibility for the accuracy of financial statements, and sought to protect the objectivity of securities analysts and to improve the SEC’s resources and oversight functions. See also Accounting and Bookkeeping.
As the accounting fraud scandals were occurring, the role of stock analysts also came under scrutiny. These analysts worked for investment banks and issued research reports on stocks along with recommendations to buy, hold, or sell the stocks. Curiously, even after Enron executives admitted to accounting fraud, most stock analysts kept a buy recommendation on Enron stock.
The fact that few stock analysts issued sell recommendations during the bear market led the New York attorney general to conduct an investigation. Most Wall Street firms and investment banks came under the New York attorney general’s jurisdiction because they were based in New York City. The investigation led to the discovery of e-mails and other evidence showing conflicts of interest. Stock analysts gave favorable recommendations to companies that were clients or potential clients of their investment banks. At three firms—Credit Suisse First Boston, Salomon Smith Barney (part of Citigroup, Inc.), and Merrill Lynch—investigators found that stock analysts were guilty of fraud. Privately these analysts had disparaged or even ridiculed the stock value of certain companies, while publicly they had recommended the stocks in an effort to win investment-banking business from these companies.
In 2003, in a settlement with the New York attorney general’s office and the SEC, ten of the nation’s leading investment banks agreed to pay a total of $1.4 billion in fines and to change certain practices. The firms pledged to strictly limit contact between a firm’s investment bankers and its stock analysts and to compensate analysts for their research rather than their ability to attract investment-banking clients. The settlement established a $432.5 million fund to provide independent stock research for investors. Two stock analysts were barred from the industry for life and fined a total of $20 million.
