Equity markets were extremely weak during the month driven by the global banking industry crisis and a sharp drop in faith in equity markets in general. The Rupee also continued to decline sharply reaching Rs 47 per USD.
Several global financials majors including Lehman, Merrill, AIG, Freddie Mac, Fannie Mae, Washington Mutual, Wachovia, Fortis, Dexia, HBOS, Bradford & Bingley and Hypo Real Estate Group had to be bailed out and history shall remember this month for a long time to come. What was talked as a sub-prime problem has since spread to the entire US financial system and has crossed the Atlantic into European financial institutions. The actual cause for this demise is extremely complex and we are not sure if anyone can actually comprehend the cause of these problems. Given the enormity of the problem, and the question if the same can happen in India is an issue that has been haunting everyone.
Firstly, one needs to understand that the banking system in India has not been carrying as much leverage as some of the global majors. For every Rs 100 of loan, the average Indian bank will have about Rs 10 of equity, and the balance Rs 90 being borrowed. The equity portion for Rs 100 of loan for some of these global companies was about Rs 5, and in some cases as low as Rs 1. It is clear such leverage should not have been allowed.
Secondly, unlike the global markets, Indian banks have majority of the loans as direct loans to end users. Globally, these institutions were carrying the loans in the form of listed securities. As a result, if the market price of these listed securities fell, the bank was forced to mark-to-market these loans. The AAA mortgage backed securities (i.e mortgage loans packaged as listed securities) of 2007 origination that were worth USD 100 at origination are currently trading at USD 51. Most of the fall in the value of such investments is due to a lack of confidence in the market, more than the expected actual loss from the investment. The extent of damage to the lower quality instruments has been much more severe, trading at USD 5 for an original value of USD 100.
Thirdly, the extent of complex derivative instruments, some of which had unlimited liability caused much severe damage to some of the companies. This market should have been brought under regulation long time back.
In this context, the near term solution of a US government led bail-out package for these banks seems to be the only possible solution. Though this bill was rejected yesterday, it seems imminent that a modified version of the same get passed very soon. The long term issue that the world needs to address is on capitalism markets itself. Whether an unbridled system of capitalism is good for the world, or does one see a modified form of capitalism with more pro-active government controls. India has been practicing the later, for probably the wrong reasons. But, this is likely to save the Indian economy some embarrassment in the near term. One also needs to remember that inflation in India is coming under control, and the RBI may step in soon with lower interest to boost the economy, if required.
More importantly during this period of market turmoil well run businesses even in the U.S. are still holding up in value. Blue chip companies like Wal-Mart, Johnson & Johnson, P&G and Colgate are within 10% of their 52 week highs. We believe that by buying high quality businesses at reasonable prices we will be able to ride out this financial storm.