financial institutions in Bermuda followed suit. Many Bermudians are having trouble understanding these changes, and totally confused as to why it is happening here, especially because we are not the United States or the United Kingdom.

Lower interest rates will particularly affect those living on a fixed income.

If you have arranged your annual budget based upon a high 7.5 percent return, a percentage and a half drop on earnings is very unsettling. Most individuals are not investment market gurus, failing to see the connection between the upward surge in stock prices, even as interest rates continue downward. This, too, is a common response.

For many years, our local population enjoyed the privilege of earning in excess of seven percent on almost guaranteed fixed deposits; we financial planners say `almost guaranteed' because financial institutions in Bermuda do not carry deposit insurance, as is commonplace in other jurisdictions. Our rates were so attractive that foreign investors opened deposit accounts here, as well as loading up on high dividend paying local stock. Bermuda had currency exchange controls in place, which minimised the amount of legal investments outside Bermuda, but also contributed to interest rate stability.

Those that attempted to break this contravention by smuggling out large sums of money, and got caught, were prosecuted. Some were found guilty in absentia, as it is could only be presumed they took their legal gains, illegally removed from the island to some other land of golden opportunity.

Technically, permission from the Bermuda Monetary Authority must still be sought to transfer or invest significant sums outside Bermuda; in reality, however for the average small investor, it may be that exchange controls are not an issue. Bermuda no longer exists or operates in isolation from the rest of the world; we are now subject to the same market forces that drive down interest rates in the United States, in the UK, in Europe, Asia and so on.

We are, folks, whether we like it or not, part and parcel of the total global economy. In a positive sense, it has given our country enormous opportunities to play the market, to attract global companies here, to present ourselves as a knowledgeable, professional island of global finance.

The adjustments made by local financial institutions to lower deposit interest rates and mortgage rates (a big bonus for those with adjustable rate mortgages) are not being done for some personal reason; nor are they imposed to interfere with the financial lives of the local population. These actions are caused by many factors, one of the most significant being that the rate of return earned by the financial institutions on their own investments in the global markets has also been lowered.

Institutions cannot loan to themselves, thus management must seek global opportunities to capitalise on the best earnings rates in order to maximise the return on their assets, thereby increasing shareholder value.

Fine verbiage, but why should that negatively affect the individual (owning time deposits) in the pocketbook? Of course, those homeowners fortunate enough to have contracted for variable rate mortgages are euphoric, because the cost of borrowing for them just dropped to an all time low this week. Those with fixed rate mortgages do not receive this advantage, but they have the serene comfort in knowing that their mortgage rate will remain the same for the life of the mortgage, no matter what happens to interest rates.

To understand why interest rates fluctuate means that we take a look at a very, very simplistic view of the very complex operations of pretend financial institution, with their supply and demand for money.

Here is our Pretend Bank, we will call it BermudaBlueSky Finance Company (BBSFC). Readers, please note, this is a composite made-up situation and not intended to reflect upon any financial institution here.

In old Bermudian days, life was grand (well, all right, it is okay to look back at everything through rose-coloured glasses); things were simpler, most Bermudians paid all of their bills in cash by making the rounds of the stores, telephone and electric company and so on. Everyone's mortgage rate (for those lucky enough to own a home) stood around nine to ten percent and fixed deposit rates hung around 7.5 percent and lower depending upon how long you were willing to lock your money up for.

BBSFC earned its money locally, for the most part, in the difference between the amount loaned out to clients by collecting a ten percent mortgage interest and from the amount taken in from clients (deposits) on which the top rate paid to them was 7.5 percent. This difference, 2.5 percent, between mortgage interest earned and deposit interest paid is called the spread (or the float).

It is not all profit, as we shall see.

It did not seem too terribly difficult to try and manage these ebb and flow.

Too many time deposits earning interest, BBSFC needed to lend out additional mortgage money to pay the deposit interest rates. An increase in the number of houses sold, more mortgages applied for, meant the company needed more time deposit volume (coming in the door) to have the money to lend out. BBSFC marketed the high interest rate to depositors, but also levied big early withdrawal penalties on high-rate long-term time deposits because they had to keep large amounts in reserve to cover new and existing mortgages.

Sounds pretty simple, money in, money out.

Time went on in paradise, a few more factors got thrown into the mix.

Inflation drove up employee wages, and other fixed costs (technology, etc) started cutting into that 2.5 percent spread. Exchange control restrictions were lifted; suddenly, there were lots of other places offshore for Bermudians to invest, where the promise of higher earnings was hard to resist.

Local money was less apt to stay local; thus, less money was going into local time deposits to be in turn, loaned out to home buyers; BBSFC increases the time deposit rate to lure money inflow and also raises the mortgage-borrowing rate. Economic conditions change again and again; mix up the equation with the situation in reverse; the real estate market goes flat, less demand for mortgage money and many homeowners prepay their mortgages off. Lots of cash volume piles up not earning mortgage interest for the company, yet the time deposit interest must still be paid out. BBSFC may consider lowering the time deposit rate to drop off the volume of cash inflow.

Other areas of impact are, BBSFC has to keep a lot of cold hard cash handy for all those customers who still get paid and pay their bills in cash. That money is restricted and cannot be invested at all, because this small economy has no place to park it for short-term earnings. In major global economies, almost all cash is swept out of financial institutions each night, loaned to other banks who pay a small rate of interest.

Thus, cash never sits idle; the cash float is always working. Financial institutions also must under country financial controls maintain adequate capital reserves against credit risks; therefore a major portion of held cash must be invested in very safe conservative investments such as US Treasury bills Continued next week CHART