BASE, HOW LOW CAN IT REALLY GO? (13/11/08)

Only two things have kept the credit crunch out of the news in recent weeks – the media hype over the Lake District mountain race and the 1700 or so runners who were never lost, and the lewd ‘on air’ antics of Russell Brand and Jonathan Ross.

But the recent announcement by the Bank of England that it was slashing base rates to 3% - the lowest level since 1955 – was met with gasps of amazement from many quarters, the loudest of which came from the popular media, catapulting the economic situation back up the news agenda.

Some were questioning whether interest rates should be cut further with forecasters even predicting they could go as low as 1% - the lowest Bank of England rate since it was set up in 1694. The question is now not whether tax cuts will be announced in the Pre-Budget Report (set for November 24) to try and stimulate consumer spending, but how much the cuts will be.

But, now that the dust has settled, the reality is that, despite what seemed like a swingeing rate cut, the tough times for business still exist. Both the Government and the Bank of England now admit that the economy is in recession. Businesses need to face up to the challenges, and under no circumstances ignore them, hoping the problems will go away. They won’t.

The banks’ problems are far deeper and more serious than first envisaged, and there may yet be further revelations about the state of their finances. This situation is highly unusual in that, in previous downturns, the banks have been strong when the economy has been weak. The Governor of the Bank of England has described the situation as “the biggest banking crisis since World War I".

Communication with banks and other lenders should remain a key priority. Despite the problems of the banks at national level, our experience is that local managers are working hard to look after their existing customers. They may have Head Office restrictions on new lending, but regular dialogue with the managers can at least help to keep existing facilities in place. If a bank does not hear from a customer then it will usually assume that things are going wrong.

Banking problems are by no means restricted to the UK: the most notable example being the Icelandic banks. Although the UK Government has provided compensation to UK personal savers, corporate investors are facing substantial potential losses: Kent County Council being exposed with £50 million at risk.

So what do the changes in the financial sectors mean for the economy as a whole?

Many people would say that we are due for a recession. The last downturn was in the late 1980s/early 1990s, and for years we have been enjoying economic growth, with a supply of easy and cheap credit. This has fuelled the housing boom and with competition amongst lenders mortgage margins have been cut to uneconomic levels.

There has also been the practice of taking short-term, 2 or 3 year, “discounted rate” deals, involving a change in lenders. As part of the remortgage process individuals have frequently cashed in on the equity in the house with additional funds raised of £10,000 or more, which has fuelled consumer spending.

In 1997 the average lender’s margin on a mortgage was 1.6% above base. In 2007 competition had reduced this to 0.2%: hardly enough for the lenders to cover their administration costs and no reserve for the proportion of mortgages that inevitably go bad. However, with house prices rapidly rising, lenders did not expect to face losses on any repossessions.

All this has now changed.  Lenders are looking to rebuild their balance sheets, and in 2008 mortgage margins are back to nearer 2%. It will also be more difficult to move lenders: falls in property valuations mean that many families are close to negative equity, or at least have a higher loan to value than the mortgage companies now require. The days of the cheap 90% mortgage, or of easy capital withdrawals, are long gone!

The following example, before recent interest rate cuts, illustrates the effect this has been having on individuals:


A person on a salary of £30,000 has a mortgage of £120,000, interest only, with a 2-year fixed rate of 5%, recently expired.  Before the latest interest rate cut, that person would now be paying around 7%, costing an extra 2% or £200 per month.  With increases in food and fuel prices probably adding a further £100 a month, the person would be £300 per month worse off, out of post tax income: equivalent to a pay cut of approximately £5,000 a year (17%).


The result of the reduction in individuals’ disposable income (both salary and remortgage capital!), coupled with the uncertainty as to what is going to happen next, both in the economy and their own jobs, has been dramatic. Any leisure related spending, such as holidays, new cars, entertainment, etc has been cut back as people focus on paying essential costs.

The effect of this has already been seen with the collapse of the UK’s third largest tour operator, XL Leisure, together with predictions of major problems in the airline industry as a whole. The motor industry worldwide in trouble and numerous other leisure related businesses such as health clubs, restaurants, etc are struggling, together with the knock-on effect on businesses which service these companies. Shops are offering big discounts as retailers struggle for survival.

Meanwhile, the property sector has suffered massively as a result of the tightening of credit. Property prices, particularly the number of recently constructed flats, are falling: with this new projects have been put on hold, and people reluctant to move house. This of course has a huge effect on all the businesses which service the property sector, and professions such as architects and solicitors.

Why the sudden big cut in base rate?

The previous small cuts in bank base rate have effectively been absorbed by lenders trying to get their margins back to previous levels, and had not been passed on to consumers. Banks are also having to pay more for the money they raise from each other on the money markets, the London Inter Bank Rate (“LIBOR”) has regularly been well in excess of base rate. 

The Bank of England therefore took the decision to cut interest rates by a massive 1.5% to 3%, and the Government put pressure on lenders to pass on this cut to borrowers. Although it will take some time for mortgage rates to settle, indications are that lenders are looking for a margin at around 2% above base.

Mortgage rates have now come down to levels which are similar to 2007, with customers paying around 5%, with variations depending on individual circumstances. This is now effectively base + 2%, rather than the previous level of base plus virtually nothing!

This move should remove some of the uncertainty on consumers’ mortgage costs.  With food and oil prices stabilising and indeed reducing (despite huge increases announced recently by the energy companies) the Government is hoping that these moves will return some confidence to consumers, and encourage them to start spending again.

Lower interest rates will also ease pressure on businesses (which have also suffered increases in bank’s lending margins), stimulate companies wishing to borrow for new investment and (the Government hopes) that banks will provide support.

The Government is desperate to return the economy to some “normality” (although what that means is open to question) to avoid massive job losses in leisure and property related industries which could cause even more serious trouble for the economy.

Unemployment has already reached 1.82 million, an 11-year high, with an increase of 140,000 in the three months to September 30. Recent job losses at British Telecom, Virgin Media and GlaxoSmithKline will push up the December quarter figures substantially.

One must also recognise, however, that controlling inflation is a Government target, usually done through changes in interest rates. The Bank of England now expects the effects of the recession to reduce inflation to 1% by 2010, substantially lower than previous forecasts. If this does not happen then with interest rates very low (and maybe going lower) raising rates in the longer term will be both economically and politically difficult – but that is tomorrow’s problem!

With all the changes having taken place, and uncertainty in the economy, normal business principles still very much apply.

Many good businesses actually end up stronger following a recession; the market may have contracted but many competitors would have gone bust or left the industry leaving those who remain in a position of strength.

Credit control and cash collection is vital. Most businesses fail because they have run out of cash - losses may be suffered temporarily in the downturn, but if cash flow is strong then they will survive.

Communicate with us. In addition to general advice, our strong links with all major banks can help your relationship with them. Up-to-date management accounts are vital, and we can provide support with these together with other accounting functions (such as payroll) that may need to be covered, short or long-term. For individuals with either mortgages or savings we can provide advice and links to specialists to enable you to get the best possible deals available in the market.

So whatever surprises there may be in store for the economy over the next few months, we at Burgess Hodgson want to work with you to maximise your business potential, whether this be short term survival or longer term growth. Don’t be the next business to make the news: talk to us.

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