Friday, February 1, 2008

Economics and Optimism

I have been noodling over a blog published by Mark Shuttleworth on economic oversteering. The basic coverage is prompted by the drop in interest the FED did last week as the markets were coming unglued, first in Europe then in the US. I am also an avid reader of a more pure-economics blog called "Naked Capitalism" and the author, Yves Smith, also usually takes the road of castigating the FED on its over reaction.

Blame the FED, cheap credit is bad okay?
The article echoes a lot of the economic coverage of the blogosphere that I read of late. Namely that, to use Mark's words, the cut was like giving crack to a crack addict. After all, everyone concurs to blame Greenspan and the low rates of the early 00's, which created a negative real rates, once you factor in inflation. This according to many led to the creation of the housing bubble. Most of the coverage usually goes further with notions of "moral hazard". The banking industry, surprise, is rotten and the salaries structures encourage reckless behavior. Namely because money managers are paid on a yearly return basis, they have all interest in investing YOUR money at high risk and getting high returns and high bonuses. By the time the risk profile you have taken on hits your portfolio they have long cashed their bonuses, they gain, you lose. Going overboard on risk is therefore a systemic problem that starts with compensation structure. That the FED encouraged this behavior by making credit cheaply available just fueled that fire. Another angle attacking the banking industry is that essentially profits are private while losses are socialized, governments are rushing to the rescue of the financial system as we speak, furthering the reckless tendency to take risks.

The credit crisis is still going furiously
Nowadays the focus and all the rage is on the ratings agency that estimate risk defaults. I was reading this morning that about $300 billion of securities were losing their AAA ratings still following the sub-prime debacle. This will of course have rippling consequences as investment that cannot hold anything under "investment grade securities" will start dumping these. The new debacle is in the insurance companies that insure against defaults on credit. They are going under big time.

I was also reading in the FT this morning that against all predictions, americans were defaulting on their houses before they defaulted on their credit cards or their cars, further deepening the housing slump. Common theory held that people would default on everything but their houses, let the car go, get the kids out of school, sell the dog, default on the credit card, but keep the house. An explanation advanced by the FT is that with declining prices, homeowners find themselves with no equity and paying a mortgage based on a value that is higher than the actual value of the house. In essence they are paying a 20% mortgage (7% mortgage + 13% price house fall). So they better move and take a new house with a new price or renegotiate their mortgages but the banks already paid 100 so they take the loss anyway. It is plausible but if that was the case I would think we would see a large volume of buying as well since people would need to relocate. I don't think we are seeing that in the market as volume is dropping. An alternative explanation I would offer is that many of these houses were actually investments and not primary residences but rather secondary or even third houses that people bought in the hope to "flip". When the markets went south it was easy and economically sound for an investor to just default on the property rather than pay their mortgage and since these were not primary residences it was an easy thing to do, just a financial decision, and a sound one, rather than relocating the kids, the missus and the dog. How do I know? I have seen it done on a million dollar home in front of my parents retirement home in the keys. It is funny how people associate "subprime" with "innercity poor" but in reality "subprime lives in a neighborhood of the Florida keys. This guy bought the house in front for a cool $1M (it is worth maybe 750) as a 3rd property and was going to flip it. He defaulted within 3 month as soon as economic hardship hit his income stream, THAT is subprime.

Credit in and on itself is not a bad thing. Credit is just a way for you to pay for things over time. Bank gives you money now, you pay for the goods, and you repay the bank over time. Or you do that directly with the car sales guy as "financing". Either way, from your pocketbook standpoint all you are doing is paying over time for a good you may not have the capital for upfront. At most what credit does is create an illusion of "growth" from a goods sold standpoint because you lower the barrier to entry to buying those goods. The problem here is that credit has been overextended and repayment is not happening, in other words, some of the earnings growth, fueled by credit will not be a repeatable on-going item for corporations. With the credit backlash happening, there is the risk of contracting further the buying ability and creating an earnings impact. All of this is worrying investors greatly.

The FED's limited monetary leverage
Which leads me to the point I wanted to make. Amid all this complicated background, brought about by some of my classmates at Polytechnique who are traders and price derivatives and structured products :) what is the FED to do? the FED controls one thing really, interest rates on Treasuries. That is a blunt instrument. Furthermore inflationary signals seemed mixed. Signs coming from Europe and China are inflationary , but deflationary forces are built in a credit crunch since if credit is not available, demand goes down and so do prices. So the FED choose to salvage the markets from their own panicky reactions.

Could the SocGen debacle have brought down the financial markets?
There is also a small events driven theory running around. I am sure many of you have read about Mr Kerviel, the french rogue trader that lost $7Bn for the Societe Generale last week. The kid, a junior trader, was supposed to take market neutral position and do arbitrage on derivatives. To play derivatives in a market neutral way you need massive amounts of capital since everything is covered. But the kid, a back-office IT specialist (blame IT!) knew how to cover his long positions with phantom shorts. In other words he never really covered $50BN long, that cracks me up. Of course the kid was returning massive returns this way but the moment the market went south so did his long position. However the real kicker is that management at SocGen decided on the Sunday night they discovered the fraud to unwind this position, thereby realizing the losses. They dug their own hole and roiled the world markets. Markets were closed in the US for MLK, further thinning volume and magnifying the selling pressure from the SocGen unwinding. Most people credit the SocGen unwinding for the nose-dive that happened last monday. Management created the loses at the WORSE possible time and created a market panic worldwide. But follow this: rumor has it that SocGen had notified the European Central Bank (ECB) and the ECB notified the FED on Sunday night.

The FED save the day
Come Tuesday the market implode with nose dive in the first 20 minutes. But the FED intervened, if the rumor is true that the FED knew of the Kerviel scandal, which was disclosed to the public on Friday, it means THEY WERE READY ON WEDNESDAY! They were ready and pounced with a rate cut that effectively stabilized the markets. The markets are still stable a week later and in fact have recovered the lost ground. The credit crisis is far from over (see above) but it is unwinding bit by bit. Keeping her steady as she goes is of paramount importance.

This is where I believe Bernanke et al to be the men of the hour with a TIMELY, APPROPRIATE AND AGGRESSIVE response. It is easy to sit in back and analyse the current movements only through the rigorous lens of strict economic theory, and nothing in what Mark says is wrong, technically speaking. But as I read somewhere, economic theory assumes humans are "rational automatas" and we are not. Optimism is an important component of market dynamics.

Behavioral black holes
These markets, i have learned to appreciate, are fraught with what I call black holes. Once irrational fear kicks in, it becomes RATIONAL to unwind positions. Market crashes aren't irrational. Many of the steps taken in the markets in the past day find grounding in reason and logic once the context of fear and uncertainty is set. Letting economic theory reign supreme can lead to absurd results. Markets sometimes needs to be saved from themselves. It is an unfortunate fact, but that is the way it is.

I believe the role of government agencies like the FED is to ensure stability, rational course and avoid these black holes of irrational horizon feeding on their own perverse logic. Human behavior feeds these markets. It is easy to set the course on a boat when the weather is clear. Everyone wants to be on deck and stir the boat. But when the storm hits you want someone that can stir "a vue" or "on sight" that reacts fast accurately and decisively. Rather than dismissing Mr Bernanke, saying he blinked and he has been a stool of the markets, I believe he has shown an amazing amount of gusto, courage, intuition, stoicness and decisiveness in dealing "a vue" with the unfolding crisis.

It ain't over till the fat lady sings, demographics as the culprit
Of course time will tell, but so far, you have to feel sorry for the guy that is finding himself thrown in the middle of this crisis and has to deal with it with the blunt instrument of monetary policy. I won't comment on the on-going debate of supplementing monetary policy with fiscal policies (what is going on in the US) because I don't understand what is going on there yet.

Also, I believe we are seeing the first shock wave of the demographic tsunami that is the retiring baby boomers. The demographics curve is not increasing any more. Like a baby being born, when the head comes out it is terribly painful, but once the head is out, expansion is done and the rest just slips out. I think that is what we are going through. Be it the real estate boom, spurred by boomers at maximum earning capacity, or the amount of savings and spending, I believe that the US economy needs to land softly in the spasms of a vertical demographic tree. THAT is the main driver, demographics. Multiply the number of people by productivity and you roughly have output and earnings. Income, which is related to output, can be leveraged by credit but at constant credit (which we are going to see) you either increase people or productivity. Many believe productivity increases are tapped out, the boomer curve certainly is, we are replacing generations but not increasing dramatically.

This phenomena will take years to flush itself out, in the meantime, avoiding panic behavior, maintaining order and to some degree OPTIMISM in the economic future of our societies is the role of the FED. Japan went through the same phenomena, to some extent, of a flat demographic tree (no expansion) and asset bubbles that exploded. Economic analysis of the "lost decade" says the problem was that banks were slow to recognize losses and move on and so the crisis lasted a decade. In the US the crisis originates in real-estate. Real-estate is traditionally REALLY slow in moving because unlike stocks that will drop in price overnight, real-estate moves on glacier times compared to the equity markets. This phenomena may be offset by the news related above that an increasing number of households default on their properties and the banks will hopefully move quicker. But still, there is a trickle of news of write-down by large banks and it doesn't seem clear at all that transparency and a correct accounting of losses is here today, still we do not know where most of these losses are... this will take some time.

In the meantime, Mr Bernanke is refilling his prescription of Xanax, Lexapro and Lorazepam, give the man a break, imho he is doing just peachy giving the downright hostile sea he is navigating.

Oben wan Bernanke, you are our only hope!

MF

33 comments:

royrusso said...

Your best blog yet!

If you have any wonder of the housing marketing and speculator involvement. Next time you're in Miami, drive around at night to the many new highrises throughout the city... take note of all the lights that are off (90%+), and realize that entire buildings were sold before even breaking ground. (In Miami, I'm thinking it was mostly due to Venezuelans moving their cash away from the clown in control over there)

"I won't comment on the on-going debate of supplementing monetary policy with fiscal policies (what is going on in the US) because I don't understand what is going on there yet."

The same political grandstanding thats gone on for a century. Fiscal policy is, as you put it, so glacierly slow, by the time it takes effect, it will have a negative outcome... as in overheating a growing economy once again. Monetary policy is THE way to go. The FED did it right this time... the correction in the housing market and internal corrections by lenders will stop the "subprime" mess from hapenning any time soon.

Then again, we can elect a democrat, roll-back the Bush taxcut, and watch the house of cards collapse. Oh, those evil little rich people! ;-)

Army No Va said...

Marc, I lived through the Austin TX bust if 1985-92 which was driven by speculators (not oil as people think...that was Houston and Dallas). Secretaries at IBM had three houses and rented them out (back then you didn't flip them so fast). They bragged about it at work. Blah, blah, blah. Classic bubble.

Highest quality areas close in went down 25%. Run-of-mill suburbs and luxury new outer suburbs down 40-50%. Land down 70-80%. (We bought a lot for $26K in 1990 that sold for $85K in 1985; owner financed, they begged us to take it!).

This time will be worse for many (but not all) markets.

The investors drop out first. But the homeowners that are underwater walk too, in cascading waves, as the equity disappears and they go underwater. They don't buy, they rent (many will go for apartments, but the ones that rent houses - then they get to move again when their landlords walk!), or move in with relatives.

My call on the bottom. 2010 at the earliest. A better indicator is when you can buy a house and rent it out with a 15%-20% positive cash flow. That price point will be the floor in many areas. Perhaps only rare, prime, extremely well located (read close to attractions/lots of employment/good schools) RE may get a bit of a pass on a big drop in price.

In Austin, the bottom for basic housing was $40-45K for a 1300 sf 3-2 (1985 price $80K) which could rent for $500/month in 1990. $80K would get you 2000+ sf. 4-2 (1985 price $140K-170K) and could rent for $800-900 per month. Middle class areas.

This time it seems the market is being manipulated more and the banks are going to get exceptions for their REO so they can keep it off the market to try to hold prices up. REO had to be sold 20 years ago, though even then it took 1-3 years to move a house in some cases. When (if?) the REO really comes on the market, the prices will be reset down...way down...to move it.

A home's instrinsic value is its income value...everything above is either due to speculation or (in a few cases) rarity/scarcity.

Roy, I hear South Carolina will fire on Ft Sumter again if Hillary is elected! :-)

aaron said...

Here's my speculation on Societe Generale:

The United States and France are learning some unintended consequences of using petrodollars to partially back the US dollar and that is Societe Generale. Societe Generale which was recently crippled by the rogue trader/subprime crisis is prime for the plucking in our "free market" capitalistic system. I won't bore you with the rest unless you want to know...here it is:http://www.talkams.blogspot.com/

Dimitris Andreadis said...

Excelent entry Marc. You may want to read this book:

http://www.amazon.com/Gold-Future-Money-Nathan-Lewis/dp/0470047666/ref=sr_1_1?ie=UTF8&s=books&qid=1201950372&sr=1-1

It's not really about investing, rather the failure of IMF, and the central banks after 1970.

FED's original purpose was to act as the lender of last resort, i.e. avoid credit panics, like the one it's happening now. It's not about defining fiscal policies and being manipulated by governments.

The planet needs stable currencies, low taxes and free-trade to prosper. Getting rid of some of the financial giants that drink our blood would help also.

On another note, I read some numbers on the the unwiding of the baby boomers effects. It may very well take 10-20 years. So there is a lot more to see there.

If anything, the US needs to reconsider their spending habbits and position in the global schene. History has shown that all Empires at some point fall apart, not because of some external force, but from the inside.

I really hope ECB does not follow suite with the rates cut, although Sarkozi is really pushing the Germans for that.

See you at JBW!

Marcf said...

Roy,

Lights are out in MIA because are out partying no? On the fiscal policy, I am not sure it needs to be political. It seemed like a good bipartisan effort in the beginning.

I was driving by Anne Cox Chambers house yesterday, the multi-billionaire lady that got Carter elected by in the days. She has three flags for "Obama".

Marcf said...

Army Nova,

I was reading some housing data on MIA dade with great interest. Basically the inventory is shooting way up but not the closing prices yet. Obviously both are linked and eventually it will have to come down. Being a buyer in the current ATL market (I haven't moved from the old house I bought when I moved here from Silicon Valley) it is a frustrating experience. If the time-line you describe will repeat itself then it is going to take some time for me :)

Go Hillary!

Marcf said...

Aaron,

interesting read. I don't see how SocGen management would hide losses on subprime with the Kerviel thing though. I mean people saw the 2B write-down last week, it didn't go un-noticed. Obviously the *attention* is on Kerviel but it all amounts to a judgement of incompetence. We will see what the hyper-active mayor of France (a.k.a Sarkozy) will do in this instance, if there is anything he *can* do.

Marcf said...

Dimitris,

I believe the FED is independent of political power. I don't believe "reconsidering" spending habits is a voluntary decision, they will be forced. If you have a link on the boomer consequences and the numbers I would be interested in reading it.

royrusso said...

Good point on fiscal policy, although one has to question whether a $300 check per household is a "stimulus plan". To me it sounds like more Chinese goods being purchased.

More power to Ann (Buffet,Soros)... what do you think the likelihood is to see them waiting in line for an MRI under a socialized medicine plan? ;-)

Knox Massey said...

Enough blather. Let's prognoticate:

Knox Massey said...

Whoops: Didn't finish.
Nice post. Nice to see that you're folowing the markets.
My thoughts: Buy gold(or silver). Buy the dollar, it'll rally. Short google short term or buy puts (400? 350?) Buy calls on Apple.
Housing market will bounce when Fed rates hit 1.5, 2.0. But, then it'll go off deep end. Sell and buy in 6-9 months and then hang tight. Financials? Holy moly, shortshortshort. Go green. Buy calls on solar.

Marcf said...

Ok, that's a fun game.

Sell gold, buy dollar, neutral on goog, appl. Housing market will go down slowly but steadily over the next 5 years. Buy financials in 4 mo. Buy green, short solar for the next 6 mo then buy.

Knox Massey said...

OK, put your $10 on the table and we'll look up in six months.

Great posts on tech. I always read'em.

Dimitris Andreadis said...

Baby boom and bust - Economist
http://www.economist.com/finance/displaystory.cfm?story_id=10534992

"Aging Baby Boomers and the Generational Housing Bubble: Foresight and Mitigation of an Epic Transition "
(it's free!)
http://www.informaworld.com/smpp/2104878056-23815571/content~content=a789053981~db=all~jumptype=rss?bios=true

Rob Lanphier said...

Great post! I wonder if inflation may end up being a corrective force for the housing bubble. It seems people get pretty irrational about selling a house below the price they paid for it (hence why the housing slump in Boston lasted so long in the 1980s, from what I understand). An odd positive effect of inflation would be to allow for a price correction in the housing market without the prices literally decreasing. That would be another argument for the Fed not worrying so much about a brief period of inflation.

aarone said...

Bingo! Rob Lanphier

Inflation has been the endgame strategy since LTCM. Inflation was to finance the war on terror, (if you didn't see it that's because you didn't look at housing or oil prices -- or other "volatiles" like food that were dropped from the CI long ago) and inflation will bail out the lenders and the housing speculators. And there were a lot of secretaries and soccer moms speculating. I happen to know a physician's assistant who quit her job, dropped out of nursing school, and lived the high life off of the gift of one rental from her parents, became a realtor, increased her holdings to three rentals and a place in a good school district for her and her newlywed husband. I feel sorry for her now.

It's people like her that the government are going to bail out, because they want her vote.

And it's people like me who didn't get into the housing market in 2004 because it looked risky, watched it inflate beyond our ability to enter by 2006, enduring told-you-sos while we watched the purchasing power of our savings reduce by half, and now feel an ominous sinking knowing that the masses of people who bought at 25% above value and expected another 25% return, won't be disappointed, and it'll be the lunch money, retirement money, and savings of the rest of us that will have to pay for it.

The value of housing won't go down, and the value of the dollar won't go up.

Marcf said...

Yeah, the part where housing was left out of Core Inflation always puzzled me. How is this not a inflating item? then of course it hit me that for most people that have houses, they rise with the floating tide and so they can hop from one house to the other, so really the ones that are feeling the initial pinch are those that don't have a house, young couples and the like. But to them, clearly this is the BIGGEST component of inflation. I remember being PRICED OUT OF THE RENTAL market in Silicon Valley and that is when I decided to come back to ATL. I very simply could NOT afford even the rent, much less the house.

I hear you guys on inflation eating away at the nominal price but not sure I buy it. Inflation is equivalent to the price going down, in term of purchasing power and "value" of your house, it is going down. The fact that people hang onto a nominal price is a superfluous approach to the problem.

I do believe that the price will go down. They are going down, they will continue to go down if we look at inventory and believe in supply/demand equilibrium. Of course these equilibriums are reached in time and right now the gap between ask and close is widening which slows down the volume. THis is a market, as many have noted that is encumbered by ego and runs deep in the psyche. Even yesterday I heard a good friend of mine say "well this street is worth 600, this one 800, but *mine* (emphasis) on mine, is worth 1M when the data I have on the sold properties in his street say exactly the opposite. That will further delay the speed at which stuff gets re-evaluated and inflation may well build 20% correction, over 4-5 years at 4% annual pace, but the economic sense would say "SELL NOW" and enjoy the time value of money. Psychology, schmicology.

The final argument for a price going down (which we are observing) is that I believe, but haven't looked at the numbers yet, that we may be at the limit of what housing can cost. I mean take an average salary, 100k. I don't mean that is average, that can be quite high, I am just using the number to make a point. Let's say that 1/3 of after tax is used to finance the home at most that 25k/year. At 5% interest (low) that is a 500k loan. The point I am making is that THERE IS A LIMIT TO WHAT PEOPLE CAN PAY FOR ON CREDIT. For the rest it is capital extensive. If you have the capital it doesn't apply of course. But with the credit going down and THE DEMOGRAPHICS going down the aggregate demand (people x money) is going down in a square fashion: less people with less money. The actual price of a house has a limit.

aarone said...

I agree with you Marc, that the actual price has a limit, unless wages go up with inflation. I am arguing pessimistically that human nature will win out over rationality, and that the government, in order to appease the majority who are in debt up to their eyeballs, will continue to print money in order to raise inflation. Inflation is the friend of the debtor.

I'll invoke Godwin on myself now, and just mention that Hitler deliberately inflated the Mark to pay off WWI reparation debt. It killed German businesses and anyone with savings in the short term (which also served his purposes, but it helped the German economy as a whole.)

I'm not saying Bush is Hitler, just that I believe the temptation to print money to bail out debt will be too great to resist.

Marcf said...

I hear you and you are probably right. I do however believe that

1/ The FED is independent of political power. The Greenspan book was great that way when he explained how Carter committed political suicide by doing the right economic thing and fighting inflation. He had no choice really.

2/ Inflation of everything will include housing. Housing prices are stretching the current debt limits (hence the subprime) so the actual prices (inflation adjusted) have to come down no matter what.

3/ Inflation will just eat at debt. Screwing the financial system by letting inflation run out of control is not going to help anyone no? People wont invest in the US, the dollar will sink further, all credibility for the US system will be gone.

I was reading an interesting article about Davos and how some non-US were chuckling at the new found humility of the US policymakers that used to run around giving lessons to the rest of the world. Apparently there were still some doing that and that elicited a few laughs.

pcleddy said...

curious what you think of this?

http://www.pbxnw.com/~paul/pdfs/cfji_chap8.pdf

i am reading through it, fascinated, but skeptical that i might be missing some piece of the puzzle

Marcf said...

PCleddy,

Fascinating indeed. I just bought the book. Will read it.

I was always puzzled by the concept of "money". That debt creates money is a well known phenomena which in an on itself is not evil. In fact it permits one to build a business by borrowing from his/hers future earnings WHICH IS A GOOD THING as it optimizes capitalism: you don't need all the capital up front but can borrow from your future success. The barrier to entry to capital and therefore further growth are lowered through debt. The capital is not created out of thin air, say like printing money, it is to be repaid from the future. I say it is a pretty nifty concept. It boils down to the concept of risk and how much of that future capital is going to disappear by default of the borrowers. But that can be priced in. With syndication it becomes fuzzy as the banks sell their debt and get the cash back which they immediately reloan as they work around their limits of what they can loan with what cash they have on their books. This way, debt multiplies without any capital backing and becomes the fiat money this guy talks about.

But the example of the civil war and Hitler's germany are interesting. Inject money and you will see inflation if demand outstrips supply. This is particularly true when money was injected in "troops" but the production infrastructure was destroyed in the US and germany. If there are 10 shoes in circulation, 2k produced each month and more money to buy them you arrive at that "$5000" shoe example the book talks about. But this is a due to LACK OF PRODUCTION CAPACITY. This is not the case today. A stimulus package of 150B like what is voted now, with 300 per household WILL result in phone purchases, food purchases and TV purchases. The production is elastic, someone WILL keep the prices in check. Add to that contraction of debt, apply the above paragraph and you have a deleveraging of the money supply that is going to further apply deflationary pressure.

I will read the book but I believe that the statement "running the money presses ALWAYS results in inflation" while historically true may be due to the fact that in the past supply was outstripped by demand, which may not be the case anymore: demand CAN AND WILL follow, debt money supply WILL decrease which all amounts to deflationary pressures. The FED MAY be right to focus on the economy growth and consumption.

Marcf said...

And for more joy, pick up the cover story of BusinessWeek: Housing Meltdown: http://www.businessweek.com/magazine/content/08_06/b4070040767516.htm?campaign_id=rss_daily

Here is an excerpt:
For another bearish view, there's what economists refer to as the Mankiw paper. In 1989, long before working in the White House as chief economic adviser or writing his best-selling textbook, Principles of Economics, Harvard University economist N. Gregory Mankiw co-wrote a paper that was startlingly negative on housing. He and David N. Weil predicted that home prices would decline by 47% after inflation over the next 20 years, based on a shrinking pool of potential first-time buyers and an expectation that baby boomers as a group would spend less on housing as they grew older.

It could be that Mankiw and Weil were not so much wrong as premature. Although boomers have thwarted expectations by adding on rooms and second homes as they age, they won't thwart nature. "At some point, death or illness will cause baby boomers' houses to come onto the market," observed John Krainer, a senior economist at the Federal Reserve Bank of San Francisco, in an in-house publication in 2005. When the huge boomer generation shuffles off, the nation's housing needs will wane. That will create an oversupply unless builders see it coming and reduce construction. Judging from the recent overbuilding binge, though, their forecasting abilities leave a lot to be desired.

royrusso said...

Marc, surely you aren't agreeing with Mankiw... a devotee of Supply-Side Economics under the Reagan Administration.

Personally, I agree with SS-Econ and its basis in the Laffer Curve. I don't expect my Krugman-reading Americans to agree however. ;-)

Marcf said...

Roy,

that is a lot of name dropping. You think that impresses me?

royrusso said...

Nah... 3 years working together, I KNOW you're already impressed with me. Its your readers, I was trying to impress. ;-)

Marcf said...

Since I don't know anyone in the list you provided, it didn't really impress me :)

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