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VOLUME II: ISSUE VI

APRIL 2012

To defaulT or noT defaulT?


Examining the future of Greece
By Guilherme Baiardi
The situation in Greece arguably took its most interesting turn earlier this month. For approximately two years now, Greece has been under the worlds spotlight, desperately trying to manage its crippling amounts of debt to avoid a default and save the Eurozone. In March, however, Greece pulled off an extremely audacious move that managed to calm investors and provide a solution to the problem, at least temporarily. Simply put, Greece carried out the largest debt restructuring the world has ever seen, rolling over on almost 200 billion in debt while avoiding a fullscale default. The Deal The bulk of the deal was the roll over of approximately 200 billion worth of government-issued bonds to longer-term debt, most of it maturing in 2042. The key point here is the haircut. Essentially, the new bonds that lenders receive will be worth less than the ones they originally held. More specifically, for every euro they would have received they will now only get 21.5 cents. Through all the complex wording and terms, what the deal essentially means is that Greece will simply not pay around 100 billion of its outstanding debt, signaling what some are calling a selective default. Why would bondholders agree to these terms? The answer is simple: if it had not agreed to the deal, Greece would have been forced to undergo a disorderly default, stopping all payments to their bondholders. The 21.5 cents on the euro is greater than the 0 cents on the euro bondholders would have gotten I they had refused to participate. Additionally, Greece would have been unable to meet its March 20 payments, and the European Central Bank would not have released the newest tranche on its 130 billion bailout package, effectively forcing Greece to default. Not surprisingly, when confronted with this choice creditors holding 85.8% of the total mount of Greek debt agreed to rollover their holdings. Through some legal clauses imbedded on the bonds (called collective action clauses), the Greek government forced the other creditors to roll over their debt as well, effectively rolling over 95.7% of their total debt load of 206 billion. The final result was a 100 billion reduction in Greeces total debt of 350 billion, reducing its debt to GDP ratio from 160% to 120%, a tremendous improvement. Triggering CDS contracts As the deal unfolded, one of the international financial communitys biggest concerns was whether the deal would trigger the credit default swap (CDS) contracts on outstanding Greek debt. A credit default contract is essentially a form of insurance on debt: buyers of CDS contracts pay a premium so that their bond holdings are insured against default. If a country defaults and the value of its bonds goes down from 100 dollars to 10 dollars, the owner of a CDS contract will be paid 90 dollars per bond. The haircut is the main bone of contention here. As previously mentioned, Greek bonds will lose approximately 78% of their value with this deal and it is only natural to think that the owners of Greek CDS would like to be repaid on this lost amount. For a long while, however, the International Swaps and Derivatives Association (ISDA) claimed that the deal would not constitute a credit event. The ISDA is a independent, overseeing body comprised of several institutions who together arbitrate over several credit events such as credit restructurings and subsequently decide whether a default has happened or not. If the ISDA decides that a company or government has defaulted, CDS contracts on that particular company or government will be triggered, and the owners of the contracts will be paid to reinstate the losses on their bond holdings. The ISDAs initial reasoning for not triggering the contracts was that the restructuring did not constitute subordination, that is, the deal didnt force bondholders to roll over their debt. As

Story continued on page 4, see Default FEDS OPERATION TWIST Tony Murphy
Page 3

GREEK RESTRUCTURING Guilherme Baiardi


Page 1, 4

OFF-SHORE DRILLING Teddy Xiong


Page 2

ZYNGA, OMGPOP DEAL James Larson


Pages 3-4

INSIDE THIS ISSUE

WHarTon underGraduaTe fInanCe CluB

aPrIl 2012
ating deck high above the oceans surface. Traditional moored semisubmersibles operate at depths of 5,000 feet, but new dynamically positioned semisubmersibles can operate at depths up to 10,000 feet. Semisubmersible rates can be between three to five-times more expensive than those of jackups. Finally, drillships operate like very large ships fitted with drilling capabilities in the middle of the hull. They are very mobile and can operate in ultra-deepwater segments of 10,000 feet and deeper. As they represent the most versatile class of rigs, drillships carry with them the highest day rates in the market. Catalysts for Growth and Emerging Trends Global energy demands will only continue to increase in the future, driven by newly industrializing countries such as China and India, which are expanding their automobile markets. This fuels greater oil production, greater crude oil prices, and greater demand for offshore drilling companies. Lately, day rates in the industry have been steadily increasing, with ultra-deepwater rigs approaching $550,000 per day and premium jackups in benign environments exceeding $130,000 per day. Meanwhile, successful oil exploration activities continue to provide drilling companies with more opportunities to tap. Last year, 23 oil discoveries were announced at average water depths of 6,200 feet, the sixth consecutive year of 20+ announced discoveries. These wells must be drilled eventually, further driving demand for offshore drilling. For example, Petrobras announced in February that it would lease 26 rigs from Sete Brasil and Ocean Rig, both for fifteen years each. Gulf of Mexico activity is expected to surpass pre-BP Macondo levels as the drilling moratorium has lifted. Finally, the key industry trend will be the shift towards ultra-deepwater rigs. Despite the expensive construction costs of ultra-deepwater rigs, demand for these rigs is in an aggressive growth phase, expected to represent more than a third of all of offshore drillings production by 2020. Companies that are positioned to take advantage of this industry trend will be able to reap the increases in revenues and profits that the industry will see. Conclusion Moving forward, the offshore drilling industry represents a strong growth sector. To take advantage of the growth, one could long a market basket of various drilling companies or evaluate specific companies. Due to the cyclical nature of the industry, one should be cautious when using traditional P/E ratios and instead utilize EV/EBITDA for a less deceptive valuation metric. Finally, like any investment opportunity, there are risks that must be evaluated. In addition to government regulation and sensitivity to oil commodity prices, another key risk is overcapacity: as day rates continue to rise and companies continue to commission new rigs, the market could reach a saturation point. However, rig construction is a lengthy process, and over the next one to three years, market demand for offshore drilling should continue to increase at healthy levels.

off-SHoredrIllInG
By Teddy Xiong
With the global demand for oil seemingly ever increasing and onshore oil wells quickly depleting, the offshore drilling industry seems primed to capture increases in revenue and profit. By 2020, offshore drilling is expected to account for 34% of the worlds oil production, up from 25% in 1990, and persistently high oil prices have driven increases in oil exploration and production. Although the most challenging and expensive means of accessing oil and gas reserves, offshore drilling yields substantial amounts of high quality crude oil and generates healthy profit margins for firms that can front the high capital required for drilling. As companies are currently experiencing record backlog for drilling contracts, it is important for the savvy investor to understand operation basics and ways to identify value. Operation Basics Offshore drilling companies secure drilling contracts from oil and exploration companies through a competitive bid basis. As a result, price competition becomes the leading factor in determining which firm secures a contractalthough quality of service, safety and operational performance, equipment suitability, and reputation also play key roles. Unlike land drilling, where a large number of firms compete for contracts, offshore drilling is characterized by a small number of firms due to the high capital barriers to entry for the construction, maintenance, and global transportation of expensive rigs. Once a drilling company has secured a contract, its future revenues will be determined by its day rates and utilization. A day rate is the amount of money a company receives for one days worth of drilling, increasing as demand for drilling services increase. Newer rigs generally command higher day rates than older rigs, and more specialized rigs also command a market premium. Utilization refers to the percentage of time that a rig was actively running and earning money during the time period and is a function of market supply and demand. Not surprisingly, revenues are heavily tied to crude oil prices: as the price of oil increases, demand for drilling increases, and both day rates and utilization increase. Types of Rigs There are three basic types of rigs that a company employs. Jackups are the most common type of offshore drilling rig and see the most volatility in day rates. They have a central barge section that floats on water and holds drilling equipment with multiple legs that extend to the sea floor. Since they physically touch the bottom of the sea floor, jackups are used in shallow water areas, typically at a depth of 400 feet, although highspecification jackups can be contracted at a premium for harsher conditions. Semisubmersible rigs operate at greater depths, floating on submerged pontoons that support an oper-

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aPrIl 2012

WHarTon underGraduaTe fInanCe CluB


is designed to lower yields on long-term bonds, while holding short-term rates little changed. This results because as the demand for a bond rises, its price rises and its interest rate falls. The bonds yield, or its overall rate of return, also falls because investors must pay more for the security. The Fed already owns more than $1 trillion in bonds, purchased over the past few years in an effort to bring down interest rates. A lot of these bonds are short-term bonds that will fully mature in the next few years. However, interest rates on short-term government bonds are already near zero. Under Operation Twist, the Fed is selling these short-term bonds and using the proceeds to buy longer-term bonds (6 to 30-year Treasuries), which have higher interest rates. As the Fed demands more long-term bonds, their interest rates will fall. Many other interest rates are tied to the long-term Treasury rates, so Operation Twist should drive down interest rates across the board. This is because investors who want a fixed return on their money will either shop for Treasury bonds, money market funds, mortgages, or corporate bonds. The higher price and lower yield on Treasuries make the other riskier bonds more attractive. Quantitative Easing, the policy the Fed enacted in 2010, was designed to have a similar effect, but it involved creating money to purchase bonds. Without printing more money, Operation Twist avoids the inflationary pressure associated with QE while still providing lower interest rates to consumers. Critics of Operation Twist claim the program has a marginal effect on long-term interest rates. Whats more, they contend that interest rates cannot solve the problems that the economy faces. The actual impact of Operation Twist on the economy will be difficult to determine. However, if consumer spending and job growth continue to improve, investors will be keen to watch how the Federal Reserve changes its game plan for recovery.

neW fed PolICY:


Operation Twist
By Tony Murphy
This March, the Federal Reserve Open Market Committee convened its second meeting of the year to discuss the state of the U.S. economy. While investors have been optimistic, with the S&P 500 up 12% for the year Fed policymakers signaled that they would maintain a cautious outlook for 2012. The Federal Reserves pessimistic forecast stands in contrast to a slew of positive economic data that has driven a stock market rally. Consumers have been spending more, and the job market has improved more than expected. However, the FOMC identified a number of risks that could derail the recovery. For one, the rise in oil prices threatens to constrain consumer spending. Other risks include the European debt crisis, the high unemployment rate, and the troubled housing market that weighs down household wealth. In the face of these headwinds, the Federal Reserve announced that it will keep interest rates close to zero for two more years. To do so, it will continue its bond purchase program known as Operation Twist. The Fed has held short-term interest rates near zero since December 2008. In theory, low interest rates create cheaper access to credit that encourages households and businesses to borrow and spend. When the economic recovery stalled in September 2011, the Fed decided to enact more aggressive measures to push interest rates even lower. It was at this time that the Federal Reserve launched Operation Twist. This policy involves selling $400 billion of short-term Treasuries while buying the same amount of long-term bonds. It

ZYnGa $200M aCQuISITIon of oMGPoP


By James Larson
Zynga, the social network game-development company headquartered in San Francisco, announced on March 21 that it would acquire OMGPOP for $200 Million in its biggest acquisition to date. In the past, Zynga has been very aggressive acquiring studios with hit games around the world. In late 2010, Zynga acquired the Texas-based mobile game developer Newtoy, Inc., which is the studio that created the popular game Words with Friends. Similarly, Zynga purchased OMGPOP largely based on the companys recent hit Draw Something, which allows players to digitally draw pop culture figures and other recognizable images and have friends guess what the drawings represent. Analysts predict this hit game could be worth a large chunk of the $200 Million price tag for Zynga, even without factoring other games in the pipeline for OMGPOP. Sources familiar with the matter have also said that Draw Something has been making close to $250,000 a day for the firm after taking out Apples 30% cut. The game is currently the top grossing app on Apples App Store.
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Shortly before the acquisitions announcement, Zynga stock shot up 6% on rumors the deal would go through. The acquisition strengthens Zyngas portfolio of games that already includes Farmville, CityVille, CastleVille, Zynga Poker, Empires & Allies, and Words with Friends. It also helps to increase Zyngas presence in the mobile market, which is an increasingly important segment amongst consumers. Draw Something is also an inherently social game, which is well-aligned with Zyngas other offerings, specifically the ones that use Facebook as a platform. Draw Something also allows Zynga to continue the process of slowly distancing itself from Facebook, or at least gives the company more diversity and less dependency on Facebook as a platform. Zynga currently derives more than 90% of its revenue from Facebook. Draw Something and Words with Friends provide revenue for Zynga that is not linked to Facebook, which investors on Wall Street would like to see more of moving forward.

Story continued on page 4, see OMGPOP 3

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aPrIl 2012

Trade of THe MonTH: SHorTCHIna


By Kevin Goldfarb
Why China? The Chinese economy has been a subject of speculation for some time now, with many expecting the worlds second largest economy to slow its growth. As you have read in past issues of this newsletter, much of the debate surrounding Chinas soft or hard landing is centered on their housing and construction sectors. The housing sector in China is reminiscent of that of the United States in 2007: on every skyline there are more cranes than buildings. This used to be indicative of healthy metropolitan expansion, a natural result of rapid industrialization and an influx of workers from surrounding rural areas. That being said, once the global slowdown hit the U.S. and Europe, consumers slowed overall consumption and thus slowed consumption of Chinese-made products. This has proved to be a huge problem for those in the Chinese housing sector because many were dependent on maintaining massive production growth in order to keep the inventory levels low. Below, I will examine a trade that will pay off in this environment. The Aussie and the Kiwi People often shy away from investing directly in Chinas exchanges because of their reputation for murky data and shady accounting practices. Once can circumvent the issue by investing in those countries from which China imports, thereby indirectly investing in China. Two of Chinas notable trading partners include Australia and New Zealand, whose economies are dependent on Chinas demand for raw materials (processed steel, iron, etc.). Since Chinas housing sector relies on the raw materials imported from Australia and New Zealand, a slowdown in housing construction will result in a dramatic decrease in Australia and New Zealands net exports. In addition, due to the decrease in net exports, demand for the Aussie (AUD) and the New Zealand (NZD) dollars will decrease, causing a sharp downturn in these export driven currencies. The differences between the two currencies are also something to keep in mind. The Aussie dollar is a lot more volatile than the New Zealand dollar (or Kiwi), sometimes losing or gaining more than 1% in a day- something most currencies just dont do. This is a good attribute if volatility is something that your portfolio can handle (depending on the size of the position, etc.), but the Aussie dollar also has more diversified exposure than the New Zealand dollar. The Kiwi has a much more constrained trading range but, due to its lower volumes, can provide a much bigger gain under eventdriven movements. Another reason to sell these two currencies, apart from the China-based strategy, is their relative strength against the dollar. The Aussie dollar is up around 1% year-to-date, having been up over 7% less than a month ago. The New Zealand dollar is up 5% yearto-date. This article was written on April 1, 2012 when: AUD/USD traded at $1.04380 and NZD/USD traded at $0.8238

Default, story continued from page 1


said before, this is highly subjective, as one might perceive the bondholders as having no choice in the matter because they were facing an impending default. This ruling, however, was made before the Greek government used their collective action clauses to force the remaining holders to accept the deal. Even though the majority of the holders agreed, forcing the few remaining ones to abide triggered a small-scale credit event, and on March 19th the ISDA determined that holders of Greek bonds would be compensated for their losses. A total of 2.5 billion has been paid out. The Future This deal, probably the most ambitious and complex debt restructuring in history, seems to have provided much needed breathing room for Greece. More importantly, it is a long desired signal that the Greek government, the IMF, and all other parties involved have finally realized that the situation in Greece was caused not by a lack of liquidity, but by insolvency. By reducing the amount of debt Greece has to pay, there is now a slight possibility that it will be able to meet its obligations. There is still much work to be done, as Greece still carries an unhealthy amount of debt, but as the international markets seem to indicate, the situation has undoubtedly made a turn for the better.

OMGPOP, story continued from page 3


While Zynga signed a five year agreement with the social networking giant in 2010 to exclusively use Facebook credits, Zynga has also been trying to expand outside of Facebook as its sole platform. In October of 2011, Zynga announced plans to create its own web-based gaming platform, Project Z, which will potentially allow the company to eliminate high fees from utilizing other platforms in the future. Currently, users would still have to sign-in via Facebook in order to use Zyngas platform. The move also allows Zynga to potentially benefit from advertising dollars generated from the site. Analysts predict that Zynga will eventually broaden its own platform to include the mobile market, which could significantly diversify its revenue sources and lessen its dependency on Facebook. Overall, Zyngas acquisition of OMGPOP and its other moves not centered on Facebook have been good for its share price. Its stock jumped 10% the day it announced that it would create a primary Zynga platform, and in general analysts on Wall Street have been looking for Zynga to expand aggressively in different areas. While many believe the firm could be destined for eventual difficulties, Zynga has clearly attempted to address these concerns of investors.

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