History of Bond Rating

The Big Three bond-ratings agencies; Moody’s, Standard & Poor’s (S&P) and Fitch, occupy a unique place in the world’s financial system. These uniquely American organizations attempt to assess the level of risk associated with securities. In the process they determine the value of securities and the credit worthiness of everything from corporations to nations.

The Big Three are so important because on some level they determine how much it will cost for governments and companies to borrow money. This is because these agencies attempt to assess how much a risk somebody is taking by lending money to a particular entity. The lender will usually base the interest rate it is willing to charge on the level risk. The interesting thing about the Big Three is that they are private companies yet they maybe the most important watchdogs in our financial system.

How It all Began

Back in the Dark Ages of Wall Street in the late 19th and early 20th Centuries investors had few ways of determining the actual value of investments. Many of the securities and equities of the era were little more than pieces of paper. Investors had no way of telling the good from the bad.

That began to change in 1900 when an errand runner turned investment analyst named John Moody published what he called Moody’s Manual. The Manual provided statistics and other basic information about stocks and industries. In 1909 after the stock market crash of 1907 Moody began offering his Moody’s Analyses of Railroad Investments. In it he attempted to grade railroad bonds and stocks the most popular investments of the day This was a book that a trader or investor could look into see the risks and costs associated with railroad investments. This was the first attempt to provide an in depth analysis of a particular class of investments.

In 1906 a company called Standard Statistics was launched to provide investors with ratings for municipal bonds, sovereign debts and corporate bonds. This company later merged with pioneering business publisher Poor’s Publishing to become S&P in 1941.

Fitch Ratings entered the business in 1913 when John Knowles Fitch began publishing his Fitch Stock and Bond Manual. In 1924 Fitch launched the first bond rating system with AAA being the best and D the worst. This became the basis for all modern ratings systems.

Nationally Recognized Statistical Ratings Organizations

The vast expansion of the financial industry after World War II led to increased demands for ratings and for oversight. In the mid 1970s the Securities and Exchange Commission began taking an interest in the Big Three’s activities. In response to this they developed Nationally Recognized Statistical Ratings Organizations or NRSROs. Financial institutions could meet capital requirements by investing in securities that received a good NRSRO.

The Big Three become Global Powers

By the 1990s the Big Three had become global powers because they were rating everything from municipal bonds to national debts. The ratings agencies were determining how much nations paid to borrow money. They also began expanding the world by opening offices in cities like London.

S&P even made national news in summer 2011 by threatening to downgrade US treasury bonds because of the political situation in the US. As securities became a larger and larger portion of the financial market the Big Three’s power increased.

Criticism of Bond Rating

The Financial Crisis of 2007-2008 led to a great deal of criticism of the Big Three and bond rating in general. Critics charged that agencies had given good ratings to questionable mortgage securities and derivatives. Other critics noted that the Big Three had given good ratings to some financial institutions including the giant insurance company AIG right before they collapsed or nearly collapsed.

Another charge was that the relationship between the agencies and some financial institutions was too cozy. The charge was that these companies were the Big Three’s customers so they had a vested interest in giving their products good ratings.

Whether these charges will stick or not is hard to determine. There were calls for regulation of the agencies and some official investigations immediately after the Financial Crisis. No concrete government action came out of any of these allegations.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuities Explained, Fixed Income Annuity, and Annuity Leads.

How Does Bond Rating Work

The best way to think of bond ratings is as a credit report for a company or agency that issues a security. Just as your credit report theoretically determines your credit worthiness, the rating theoretically determines the worthiness of the bond issuer and the potential value of the security itself.

It should be noted that a bond rating goes into much greater detail and depth than your credit report. The only information your credit report contains is brief accounts of financial transactions that you have made. Your credit report will not say how much money you have in the bank or what your income is. Nor will it list the value or potential value of your assets. The analysts that create bond ratings take all of these factors and much more into account when they rate a security.

The Bond Rating Process

To see how the bond rating process works we’ll look at the story of a fictional bond. The City of Mayberry decides to issue some bonds to pay for the construction of a new sewer plant. When these securities reach the market, potential buyers will want to know if they are a good investment or not.

In an effort to answer this question analysts working for the Big Three Bond rating firms (S&P, Moody’s and Fitch) will take a look at the Mayberry Issue. The analyst will ask a number of questions including: how likely is Mayberry to repay the bonds? How likely is Mayberry to default on the bonds? Is Mayberry capable of generating enough revenue to pay off the bonds?

The analysts will look at a wide variety of factors such as Mayberry’s tax base, its’ history of paying past bond issuers, the viability of the new sewer plant, future revenue projections and other liabilities the city might have. The main thing they will be trying to determine is the level of risk that investors would take when they purchased the bonds.

Grading Bonds

Once the analysts have completed their work they will issue a report about the bonds. More importantly they will rate the Mayberry by assigning it a letter grade. The idea here is to make it easy for people to evaluate securities. A person can tell how good or bad a bond is by looking at a simple letter grade.

If the analysts at Fitch or Standard & Poor’s (S&P) think the Mayberry bonds are really good investment they will give them the highest rating of AAA. The analysts at Moody would assign a similar rating of Aaa. The higher the rating the better the analysts believe the bond is. The lower the rating the greater the risk the analysts think the bond is.

Bonds rated below a certain level are considered non-investment grade or junk. That means the analysts think there is an unnecessarily high level of risk associated with them. If the analysts at S&P learned that the Mayberry City Treasurer had embezzled the proceeds of a past bond issue and skipped town they might rate the city bonds a B- which would make them junk. Junk bonds often pay a much higher interest rate in order to attract investors.

How to Use Bond Ratings

The best way to use bond ratings is to only purchase securities that get a good rating from all three firms. This would be Aa3 or higher from Moody’s, or AA- or from S&P and Fitch. If one firm rates a bond lower than that or non-investment grade it would be a good idea to stay away.

Something to keep in mind is that on some level bond ratings are based on the opinions of bond analysts. There have been some serious criticisms of the ratings agencies and allegations of collusion with financial industry players. There it is always a good idea to view the ratings with a little skepticism.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Ordinary Annuity, Retirement Annuity, and Income Annuity.

How are Credit Cards Regulated?

In the United States credit cards are regulated by the federal government. A 1978 US Supreme Court decision called Marquette National Bank vs. First of Omaha Services effectively stripped the states of their power to regulate credit cards issued by institutions in other states. In this decision the court ruled that the federal government not the states regulates banks that operate in more than one state.

Marquette as it is called essentially made it illegal for states to impose limits or restrictions on credit cards issued across state lines. Among other things it overturned usury laws which limited how much interest card issuers could charge. This paved the way for the modern credit card industry and the high interest rates many people complain about.

Today two different federal agencies have legal responsibility for regulation of the credit card industry. The Federal Deposit Insurance Corporation or FDIC has authority over the cards because they are bank products. The newly formed Consumer Financial Protection Bureau also has authority over credit cads because they are consumer financial products.

FDIC and Credit Cards

The FDIC regulates credit cards under Regulation Z or its truth in lending provision. Section G of Regulation Z spells out the general regulation of credit cards by this agency.

Among other things it limits fees including late fees that cardholders can be charged. It also limits fee increases and effectively bans the marketing of credit cards on college campuses. These regulations were implemented to stop abuses related to the card industry. The FDIC also has authority over lines of credit issued by banks. Any card issued by an FDIC insured bank is subject to FDIC regulation.

The FDIC issues regulations about such issues as privacy, and identify theft and fraud. Credit cards linked to mortgages and real estate lines of credit would also be regulated by this agency.

Card Act and Consumer Financial Protection Bureau

The Consumer Financial Protection Bureau was launched in July 2011. This agency’s role is to enforce all consumer financial protection laws including those governing credit cards. The laws it is charged with enforcing include the Credit Card Act or Credit Card Holders’ Bill of Rights passed in 2009.

The Card Act makes it illegal for credit card companies to raise the rates on existing balances. It also makes it illegal for companies to impose over-limit fees on cardholders after they go over the limit. Another provision requires card issuers to openly report rates and fees. It banned many practices that were considered unfair including double billing, and adding of fees on cardholders that pay on time.

A major provision is that credit card statements must be mailed 25 calendar days before the billing date. Payments made before 5 p.m. on the due are considered on time. It also made it illegal to issue cards to people under 18 years of age.

As of December 2011, it was unclear what efforts CFBP is making to enforce the Card Act and other laws. The agency’s website stated it was studying the issue. The CFBP website is collecting complaints against card companies from consumers. Whether it will investigate these reports, take legal action or turn the complaints over to another agency such as the FBI for investigation is unclear.

Credit Card Regulation and You

The CFBP seems to be taking the lead in enforcement of credit card regulations in the US. Therefore the first action you should take if you have a complaint about a credit card is to report it to that agency. Unfortunately the scope of the CFBP’s powers and its ability to enforce regulations is unclear at this time. Persons with complaints about card companies should consider other actions such as contacting an attorney or working with other government agencies in addition to making a complaint.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Single Premium Immediate Annuities, What is an Annuity, and Current Annuity Rates.

How are Annuities Regulated?

The regulations affecting annuities are a little confusing because there are different rules for different kinds of plan. The way your annuity is regulated will depend upon the kind of plan that you have.

State Regulation of Annuities

The reason for this is that most annuity contracts are considered insurance policies. Insurance policies are regulated by state governments, usually by the state commissioner of insurance but sometimes by the state attorney general. Even though the federal government has the power to regulate insurance, Congress has chosen not to regulate it.

This means that a straight annuity contract such as an immediate annuity would be regulated solely by the government of the state that was issued in. A person would have to check with the state government or a knowledgeable attorney to determine what regulations were in place. You can learn which agency is in charge of insurance regulation by checking the state’s website.

It is also entirely possible that your annuity could be regulated by another state. If you purchased a contract in New York but moved to Florida, your policy could be regulated by New York law. That is why it is always a good idea to check with an attorney or the issuer to see what regulations are in force.

Federal Annuity Regulation

A good rule of thumb is that any annuity that has no investment component is considered an insurance policy. That means it is regulated by the state governments. Any contract that has an investment component can be regulated by the SEC.

The Securities and Exchange Commission regulates variable and indexed annuities because those vehicles are partially invested in the stock market. The SEC views these vehicles as securities rather than insurance policies so it claims jurisdiction over them. This means that this kind of plan must be sold by a broker with an SEC license. All indexed annuities have to be registered with the SEC.

It also means that anybody that tries to sell you this kind of plan must make its prospectus available to you. The prospectus is a document that outlines everything about the plan including rates, rules, provisions etc. It is always a good idea to read the prospectus two or three times before spending any money.

Annuity Regulation and You

One thing to remember is that an annuity is at heart a contract. Under our legal system it is the responsibility of those who enter into a contract to obey it and to enforce it. That means the insurance company has an obligation to pay the beneficiary and you have an obligation to follow the terms of the contract. It always means that you may have to take action to enforce the contract yourself.

If you get into a dispute with a company that sold you an annuity you may have to hire an attorney and take the company to court. Government regulators with limited resources and budgets may consider the matter a private dispute between you and your insurance company. Under our system such disputes are supposed to be settled by the courts or by an agreement between the parties involved.

How Legal Decisions about Annuities are Made

In the courts annuity regulation is based upon statutory laws (laws passed by legislatures and Congress) and case law. Case law is earlier court rulings upon the same subject. Most of the law governing annuity contracts is case law which is constantly changing so you may need to talk to a knowledgeable lawyer to determine what rights you have.

Something else to be aware is that some contracts could mandate arbitration. That means the dispute will be settled by a third party called an arbitrator. This is an individual usually an attorney who will listen to both sides and make a decision. The drawback to this arrangement is that the arbitrator’s decision cannot be appealed. If the annuity contract mandates binding arbitration you may have choice but to submit.

Therefore it is always a good idea to conduct a little research and learn the basic legal rules governing annuities in your state. That way you can avoid a lot of legal bills.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Definition, Annuity Rate, and Best Annuity Rates.

How does Progressive Income Tax Work?

The concept behind a progressive income tax is a very simple one. Those who make more money will pay a higher income tax rate. The reality is far more complex because of a wide variety of factors.

In the United States the federal income tax and some state income taxes are progressive. Some states have another kind of income tax called a flat tax. Under a flat tax everybody pays the same rate. There are also some states with a hybrid system where everybody pays a flat tax but some rich people pay a higher rate.

Progressive Tax Overview

The best way to see how this tax looks is to take a look at the tax rates mandated by the current Internal Revenue or federal tax code. This law currently mandates six tax rates of 10%, 15%, 25%, 28%, 33% and 35%. Everybody that makes more than $8,375 a year in taxable income has to pay one of these rates. That means everybody gets an automatic $8,375 a year tax exemption.

If Bob Cratchet earned $10,000 a year he would have $1,625 in taxable income so he would pay $162.50 in income taxes. If Bob’s employer Mr. Scrooge earned $500,000 a year he would pay a 35% income tax rate because he earns more than $373,650 a year. 35% is the current maximum tax bracket under federal law. Therefore Mr. Scrooge would pay $175,000 a year in taxes.

That is how the progressive income tax is supposed to work. In real life though Bob would probably pay no income taxes, and Scrooge’s tax bill would be far less. Both of them would take advantage of deductions in order to lower their taxable income and the amount they owed. For example if Scrooge was able to lower his taxable income to $212,300 he would pay a rate of 28% or $140,000 a year.

Taxable Income vs. Real Income

The reason for this is that the income the IRS uses for tax purposes on and your real income are two different things. If Yogi made $100,000 a year his taxable income should be 25%.

Now let’s say Yogi is a pretty smart guy so he has a few deductions. He’s married and he has kids. He owns his own business so he can write off of a lot his day to day expenses. He owns his house so he has a mortgage deduction. Yogi also gives a lot of money to charity. If the deductions reduced Yogi’s taxable income by $40,000 a year he would only pay a tax rate of 15% because his taxable income would be $60,000 not $100,000.

This is why many of us spend so much time and effort on our tax returns every year. We want to reduce our taxable income so we can reduce our tax rate and avoid the progressive income tax.

How it is Enforced

When you hear that somebody is facing a tax audit that means the IRS is investigating them to see if the information they reported on their tax return is accurate. The IRS would check to see if all of Yogi’s tax deductions were legitimate and if his real expenses matched what he listed on the return.

This is the current federal income tax system in the United States and it affects the states that collect income taxes as well. Most states simply use the information on your federal tax return as the basis of your state return. If Yogi’s state had a 10% flat income tax it would simply collect that on whatever amount appeared on Yogi’s federal return.

Whether the progressive income tax system will survive or not is debatable. It will probably be around for the foreseeable future unless some sort of financial catastrophe or political pressure forces Congress to radically alter the tax system.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Calculator, Annuity Interest Rates, and Annuities Good or Bad.