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Easy credit conditions In the wake of the dot com burst and the 9/11 attacks, the Federal Reserve chairman Alan Greenspan initiated a series of interest cuts that brought down the Federal Funds rate to 1% in 2004 in order to keep the economy strong. In addition, between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required U.S. to borrow large sums from abroad, much of it from countries running trade surpluses. Large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. This created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. This created easy credit conditions for a number of years prior to the crisis, fueling a housing construction boom and encouraging debt financed consumption. The combination of easy credit and money inflow contributed to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. Sub prime lending The general notion in the U.S. was that the housing prices are always rising. This belief that housing is a safe and good investment led to mania for home ownership. People who already had a home were prepared to buy another. Those who could not afford a house contacted a mortgage broker who got them in touch with a mortgage lender. The investment banker then borrows millions of dollars and offers to buy the mortgages, converts them into Collateralized Debt Obligation ( CDO ) which contains 3 tranchesunsecured (risky), Mezzanine (okay) and Senior Secured (safe). As the payments on the mortgages come in, the safe tranche fills up flowing down to the okay tranche and then finally to the risky tranche. If some borrowers default on their mortgages, less money comes in and the bottom tranche may not get filled. To compensate for the additional risk, the interest was higher in the bottom tranche. The investment banker sold these tranches to investors, hedge funds, pension funds etc. In the beginning, these tranches were overflowing and everyone was getting great returns. So the investors asked for more tranches from the banker who asked for more mortgages from the lender. But all those who qualified for a mortgage already had one.
The prime borrowers now faced a strange situation. Now suppose the value of the assets declines by about 3% to $300. They found out that their mortgage payments were now greater than the value of the house they owned so they also put the house on sale. This adverse condition of the banks was also accentuated by increased debt burden and over leveraging. As more and more sub-prime mortgages default. This is summarized by their leverage ratio. Many financial institutions were facing this scenario. the sub prime borrowers defaulted on their loans and the banks get their houses which were rising in value.S. The SEC has conceded that self-regulation of investment banks contributed to the crisis Each of the five largest investment banks took on greater risk leading up to the subprime crisis. It is an accounting identity (a rule that must be true by definition) that assets equals the sum of liabilities and equity. let's suppose an investment bank has $310 in assets. These firms had ratios closer to 30. This is a leverage ratio of 300/10 or 30-to-1. A highly leveraged institution can have its equity wiped out due to relatively minor swings in the value of its assets. the Securities and Exchange Commission relaxed the net capital rule which enabled investment banks to substantially increase the level of debt they were taking on. they typically issue new common stock shares to the public in exchange for funds. the U. fueling the growth in mortgage-backed securities supporting subprime mortgages. the house ownership passes on to the bank. In the event of a default in mortgage payments. In 2004. The mortgage pool was now running dry as the mortgage payments were not coming in. The institution still owes its debt holders $300. Sub prime lending required no down payment or proof of income. So the banks now stop buying or lending anything. As one would expect. However. . which is the ratio of total debt to total equity. This led to a series of foreclosures. this dilutes the ownership of current shareholders.This gave rise to sub prime lending. A higher ratio indicates more risk. the value of these houses gradually start to plummet as the supply now far exceeded the demand. this would be great for them. The lenders start writing up riskier mortgages. so equity must be zero. To get more equity or capital. But the investors do not want it as they already own CDOs that are plunging in value. A ratio of 10-15 is more typical of a conservative bank. These mortgages became riskier to the point where one could get a mortgage without presenting any document at all! This was the turning point. $300 in debt and $10 in equity capital. For example. these firms significantly increased their leverage ratios. The bankers thought that since the housing prices are always rising. From fiscal years 2003-2007. The investment banker now held hundreds of worthless CDOs which he needed to sell to pay back the huge sums he borrowed to buy the mortgages.
and provided asset management services and credit protection products to investors. a New York-based fund. It was under pressure after it was accused of missing numerous red flags and ignoring tips on Madoff's alleged fraud. Approached Goldman to structure the deal through which he could monetize his views on the sub-prime mortgage market.. The SEC contends that the firm did not disclose the role of Paulson. Paulson. which took a bearish view on subprime mortgage loans by purchasing protection through credit default swaps ( CDSs ) on various debt securities.now recognized as a heavy bettor against the subprime market. a hedge fund manager. is a global investment banking and securities firm which engages in investment banking. PARTIES INVOLVED AND MOTIVATION OF DIFFERENT PARTIES Goldman Sachs.John Paulson is the founder and president of Paulson & Co. Inc. and have recently received significant media attention. The agency charged a case against Goldman for fraud. a larger and more dilutive issuance of shares is required. Their main business is trading for their own accounts and creating trading opportunities for clients for which they get a fee. ACA Management ±ACA was the asset management subsidiary of ACA Capital Holdings. Hedge fund manager. Paulson created the Paulson Credit Opportunities Funds. ACA acted as the Portfolio Selection Agent for the 2007-AC1 transaction.SEC is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry.The Goldman Sachs Group. Beginning in 2006. to potential investors. When share prices have been reduced as was the case in 2008. investment management. Goldman Sachs's duty was to serve as a market maker whose job was to structure and execute a transaction to meet multiple client needs. Paulson. securities.. invested $42 million in the . ABACUS 2007 AC1 The deal became a subject of controversy when the Securities and Exchange Commission ( SEC ) filed a civil fraud lawsuit against the investment bank on grounds of misrepresenting material facts in the offering document. Securities and Exchange Commission (³SEC´) .was allegedly involved in the selection of the securities that went into the deal. These funds earned substantial profits. Inc. and other financial services primarily with institutional clients.placing downward pressure on the stock price.
and sold protection to Goldman Sachs on the $909 million notional amount super senior tranche of the transaction. ABN AMRO was one of the largest banks in Europe and had operations in about 63 countries around the world.HE indexThe ABX. Moody's and Standard & Poor's. The premium rate for an ABX.A credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In January of 2007. ABN Amro assumed the credit risk tied to the highest-quality parts of the Abacus CDO. OTHER WAYS TO MONETIZE ONE S VIEWS ABX.2007-AC1 notes. ABN Amro.HE index tracks the prices of CDS contracts written on a fixed basket of twenty. Paulson s selection criteria favored RMBS that included a high percentage of adjustable rate mortgages. California. IKB launched Rhinebridge Plc. called the fixed leg. and Banco Santander acquired ABN AMRO in 2007. Credit rating agencies. a consortium comprising RBS.Between 1991 and 2007. including multiple ABACUS transactions. Paulson performed an analysis of recent-vintage Triple B RMBS and identified over 100 bonds it expected to experience credit events in the near future. Florida and Nevada that had recently experienced high rates of home price appreciation. In late 2006 and early 2007. IKB Deutsche Industriebank -IKB is a German Bank founded in 1924. In the biggest banking takeover in history. meaning it should have been a safe investment. Goldman Sachs was working with IKB on a number of transactions. The deal had received the highest possible credit rating . Fortis. PAULSON S STRATEGY Paulson s funds bet aggressively against the mortgage market.HE index of a given vintage and credit rating is fixed until the vintage expiry date when the notional balances of the referenced . The protection buyer of an ABX.HE index of a given credit rating pays the protection seller a onetime up-front fee of par minus the observed market price of the ABX. through credit default swaps. a structured investment vehicle that invested heavily in the United States subprime market.by the top two agencies. and a high concentration of mortgages in states like Arizona.HE index plus a monthly premium. relatively low borrower FICO scores.stamped triple-A .
a bet on the portfolio performance. and/or bets on baskets of named securities since the referenced obligations of each index are known.HE indexed CDS allows short-sellers to either take large directional bets on the mortgage sector or individual banks in the sector.S.000 and then sells again at $110. In other words. An ETF's value is tied to a group of securities that compose an index. CBOE. These products provide opportunities for protection or profit in up or down markets.S. Although the exact size of the short-selling bets on the ABX. and extend to the housing industry the same tools for risk management and investment that previous CME innovations have brought to agriculture and finance. 2008)) and the Goldman Sachs bet on the ABX. Miami (MIA). ETFs are traded and exploited like any other stock on an exchange. Dow Jones and Company. The CME can be used by a homebuilder as a hedging tool by selling a futures contract at current prices to offset the risk of falling prices. defaulted. Investors are able to short sell an ETF. The ABX. Investors can also buy contracts based on a weighted composite index for all ten cities. also known as an exchange-traded product (ETP).obligations have fully amortized. ETFsAn exchange-traded fund (ETF).C. (WDC). is an investment fund traded on stock exchanges. Stock Market IndicesAmex. Boston (BOS). real estate values. San Diego (SDG).000 the index records a ten percent increase. The following markets are tradable: Composite Index (CUS). New York (NYM). Las Vegas (LAV). subprime RMBS pools. and Washington. Unlike either options or futures the investor is not offering to buy anything and will not end up owning a single house. it is known that these positions delivered two of the largest single successful payouts in the history of financial markets: the Paulson & Co. 2007)). . series of funds that secured $12 billion in profits from subprime bets based on the ABX indexes in 2007 (Mackintosh (January 15. Chicago (CHI). buy it on margin and trade it. Denver (DEN). Los Angeles (LAX).0 billion of losses on Goldman's $10 billion sub-prime portfolio holdings in 2007 (Kelly (December 14.HE indices is unknown. Chicago Mercantile Exchange The quote from the CME web page on housing futures reads: "CME Housing futures and options are the first comprehensive financial tools that make it possible to trade U. If a house sells at $100. and/or have been pre-paid equally weighted U.HE index that generated nearly $4 billion of profits and erased $1.5 to $2. NASDAQ. San Francisco (SFR). Standard and Poor s etc. A person who feels that the housing prices are going to rise significantly can purchase a futures contract at current prices. much like stocks. D. are certain indices that allow investors to monetize their views on performance of a number of companies.
It did that by stepping in to buy the riskiest portions of the CDOs. which was disclosed in some offering documents. while the investors in the supposedly safer parts of the security suffered big losses. traders said. generally triple-A rated portions of the CDO could not be sold. and other top banks in the run-up to the crisis to help create nearly $40 billion in collateralized debt obligations that in many cases the hedge fund also bet against. Those deals essentially were portfolios of derivatives that aped the performance of dozens of residential and commercial mortgage-backed securities. Magnetar offset its risk by betting against the default of these securities using instruments called credit default swaps. One feature of the Morgan Stanley deals was a structure that could increase the magnitude of the bullish investors' exposures to the underlying mortgage bonds. the supposedly least risky. It helped keep sales growing even as the housing market started to stumble. . People involved in the deals which were made just as the housing market was beginning to fall apart -said Magnetar pushed for particularly risky assets to go into the investments. Magnetar also received regular payments as its investments threw off income. Dead Presidents Deal Morgan Stanley arranged and marketed CDOs to investors. Without a buyer for the riskiest slice. Magnetar ended up making big profits when these CDOs collapsed. and its trading desk at times placed bets that their value would fall. By buying the risky bottom slices of CDOs. Since it owned a small slice of the CDO. created in mid-2006. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs. Magnetar didn t just help create more CDOs it could bet against. This feature. JP Morgan Chase. made it more likely that such investors could lose money if the underlying bonds performed poorly. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure.OTHER SIMILAR DEALS DONE AT THE SAME TIME Magnetar worked with Citibank. Merrill Lynch. Among the Morgan Stanley deals that have been scrutinized are the Jackson and Buchanan CDOs.
albeit from the category of 2006/2007-vintage Baa2-rated subprime RMBS. Libertas It is believed that Morgan Stanley may have engaged in fraudulent sales practices related to the sale of Libertas CDOs. Morgan Stanley knew securities in the Libertas CDOs were suffering a dramatic rise in delinquencies. the synthetic portfolio consisted of 90 Baa2 rated sub-prime residential mortgage backed securities ( RMBS ) issued in 2006 and early 2007. PORTFOLIO COMPOSITION Like countless similar transactions during 2007. bearish side of these transactions. These positions weren't disclosed in some deals. . but provided a misleading "risk factor" in a prospectus that rising delinquencies "may" hurt values in the $1 trillion residential mortgage-backed securities market.Morgan Stanley traders took the more profitable. according to traders. Form of CDS Bond Protection Buyer Short the credit risk Protection Seller Long the credit risk Payment only if credit event occurs Physical Settlement and Cash Settlement In a physical settlement. ACA ultimately approved 90 securities that it stood behind as the portfolio selection agent. Morgan Stanley knew the CDO's assets were much riskier than the ratings suggested but was highly motivated to sell the CDOs to investors because the firm was simultaneously "shorting" almost all the assets. the buyer of protection receives the net difference between par and the market price (also known as the recovery value) of the defaulted security. the buyer of protection delivers the defaulted bond to the seller and receives par in return. In a cash settlement.
interest shortfalls. The Pay-As-You-Go System ABCDS are structured as pay-as-you-go ( PAUG ) contracts with a physical settlement option. Credit Events There are generally four . to terminate the CDS contract by physical settlement. Under PAUG. delivering the bond to the protection seller in exchange for par in return. Maturity Date The scheduled maturity date of ABCDS is the legal final maturity date of the reference bond. prepayments. in whole or in part. the buyer of protection has the option. and an additional fixed payment leg. and only the status of that bond (e. Each ABCDS is written on a specific security. a floating payment leg. The buyer continues to make premium payments based on the notional of the ABCDS contract adjusted for writedowns and paydowns.. . and the protection seller makes payments equal to the writedown amount and. to some extent. etc.g. interest shortfalls.) is relevant to the parties in the contract. Maturity extension: The legal final maturity date of the reference cash bond is extended.Physical Settlement Bond Protection Buyer Par value of bond Cash Settlement 100-recovery rate Protection Buyer Protection Seller Protection Seller Asset Backed Credit Default Swap (³ABCDS´) Referenced entity in each ABCDS is a single ABS security.credit events. as defined in ABCDS: Failure-to-pay: The reference cash bond fails to pay all principal by the legal final maturity date. Write-down: The balance of the reference cash bond is written down. There are three payment legs to each ABCDS contract: a fixed payment leg. If a credit event occurs. the CDS contract remains outstanding. writedowns. Distressed rating downgrade: One of the three major rating agencies downgrades the reference cash bond to Caa2/CCC or below.
An investor with a particularly strong view or with a larger portfolio could. CDS also allow investors to acquire more exposure to a specific bond than is available in the cash market. Interest Shortfall Mechanics No Cap: The seller s obligation is equal to the full interest shortfall in each period. sell protection in a $10 million CDS contract referencing a BBB bond that has only $5 million outstanding. Increase Leverage Since CDS require no initial cash outlay (beyond any margin requirements). WHY ABS IS USED Acquire Credit Risk ABCDSs provide investors access to credit risks and rewards they otherwise may not be able to acquire due to scarcity of cash bonds. Investors with relatively high funding costs should find it more attractive to sell protection through ABCDS than to buy the cash bond and fund it on balance sheet.Pay-As-You-Go Payment Mechanics Payment Fixed Payments To/From Buyer to Seller Amount (s) CDS Premium Floating Payments Seller to Buyer Principal Writedowns Interest Shortfalls (up to cap) Principal Shortfalls Reversed Principal Writedowns Reimbursement of Interest Shortfall Payments Reimbursements of Interest Shortfalls Additional Fixed Payments Buyer to Seller Interest Shortfall It is the aggregate amount of interest payments from borrowers that is less than the accrued interest on the loan. for example. Variable Cap: The seller s obligation is limited to LIBOR (London Interbank Offered Rate) + CDS premium. Hedge Exposures . Fixed Cap: The seller s maximum exposure is capped at the CDS premium. they provide an efficient means of making leveraged credit investments.
By October 24. 06-2 ). Short the Market ABCDS allow investors to express a bearish as well as bullish view on the credit quality of ABS collateral in general. 99% of the portfolio had been downgraded. . January 2007: Goldman approaches ACA to propose they serve as the Portfolio Selection Agent for the proposed CDO. and other investors. investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Our fee was $15 million.e. 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. We were subject to losses and we did not structure a portfolio that was designed to lose money says a Goldman Sachs spokesperson. concocted by Paulson. lost more than $90 million. in an email with the subject line Paulson Portfolio. The parties agree on the final portfolio of 90 RMBS securities on February 26. bank and originator margins have compressed. 2008. Paulson s opposite CDS positions yielded a profit of approximately $1 billion for Paulson. ABN Amro Bank NV lost more than $840 million and Dusseldorf. increasing their desire to hedge pipeline risk (i. 2007 to February 26. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. itself. Goldman Sachs. By January 29. TIMELINE OF EVENTS December 2006: Paulson & Co.e. according to the SEC. 2007. This initial portfolio consisted of 123 subprime RMBS. the risk of spread widening after loan rates are locked but before they are closed and sold or securitized). January 9. approaches Goldman Sachs expressing interest in purchasing protection on (i.ABCDS can be used as hedging instruments for mortgage originators.. betting against) a basket of a BBB-rated. Germany-based IKB Deutsche Industriebank AG lost most of its $150 million investment. 2007. As a result. Goldman sends ACA the first proposed portfolio. As the market grew. subprime-backed mortgage bonds that closed around the second half of 2006 (i. The subprime mortgage market experienced an annualized growth rate of 50% over the past four years before 2007. The deal closed on April 26. banks. * Goldman Sachs Lost Money On The Transaction. 2007: Paulson and ACA debate the contents of the portfolio.e.
while Paulson s investment strategy is well known today. ACA Management exercised its own judgement in deciding which assets were included in the portfolio and rejected dozens of those suggested by Paulson. According to Goldman. Paulson's plan was to bet against the CDO. Allen Stanford. wanted to bet against the housing market. All participants in the transaction understood that . Paulson worked with ACA to determine what went into the CDO. Paulson & Co. according to the SEC. In that sense. Thirdly.A big hedge fund. GOLDMAN S CLAIM AND CASE Their claim is that the firm lost $90 million on the transaction. nothing in the record establishes that Paulson s involvement would have been significant in early 2007 to anyone involved in the 2007-AC1 transaction. But Goldman "knew that it would be difficult. This information was accurately disclosed. Paulson bet against the CDO and made a profit of $1 billion.SEC S CLAIM AND CASE The SEC faces political pressure to prove it is on the case of protecting investor interests. if not impossible" to sell the CDO if investors knew that a hedge fund played a "significant role" in deciding what went into the CDO. according to the SEC. It talked to Goldman about putting together a CDO full of mortgage-related assets that Paulson thought were likely to lose value. Goldman argues that the buyers of these products were sophisticated investors with their own sets of models to evaluate the risk associated and they should have known that these transactions involve betting on the success and failure of the underlying mortgages. Goldman said the assets in the CDO were "selected by ACA". the SEC says. then bet against it. Indeed. Secondly. Paulson paid Goldman $15 million for putting the CDO together. so it would profit if the CDO lost value. ACA had the final say in deciding what went into the deal. called ACA Management. which was in the business of selecting assets for CDOs. Case and claim. but also for failure to catch Ponzi schemes such as those of Bernie Madoff and R. ACA put its own money behind its analysis by investing in the notes itself and entering into a large swap referencing the portfolio. Goldman "misled ACA into believing that Paulson was investing" in the CDO. In its marketing materials. rather than betting against it. as it had a net long position that soured when the CDO went bust. Investors in the CDO lost over $1 billion. what was important to the note investors were the offering documents descriptions of the Reference Portfolio. So Goldman brought in another company. The agency is under scrutiny not only because of its role as a Wall Street cop as the financial crisis emerged. The marketing materials didn't mention Paulson..
Fourthly. Goldman Sachs had a duty to keep information concerning its client s (Paulson s) trades. opines Shepherd Smith Edwards and Kantas. POLITICIANS¶ VIEW Democrats called for greater regulation of Wall Street. Finally. Senate Banking Committee Chairman Chris Dodd-we don't need to know the outcome of this case to know that the opaque nature of unregulated asset backed securities fueled the financial . and that it shouldn't have mattered that Paulson was betting against ACA's interests. there is no basis to suggest that the portfolio would have performed any differently or that the economic outcome for the participants would have changed in the least had Paulson s role and interest been more transparent." faulty government regulations are to blame for most of the economic turmoil of the past few years. as a broker-dealer acting as an intermediary on behalf of a client. the bond insurer involved in the Abacus deal with Goldman. the SEC s proposed theory ignores the fact that. WALL STREET¶S VIEW Buffett said he's studied the charges against the investment bank and has "no problem with that Abacus transaction. a hedge fund manager at Fleckenstein Capital Management. It's far from the worst sin of this mess.". A disclosure that the relatively unknown Paulson was the entity to which Goldman Sachs transferred that risk would have been immaterial to investors in April 2007. Buffett said ACA.someone had to take the other side of the portfolio risk. was responsible for assessing the transaction's risks. "The players on both sides of the trade that the SEC has targeted knew the risks and knew one side was bound to lose. positions and trading strategy confidential. Synthetic derivative investments are so highly complex that even highly sophisticated investors can be defrauded. not investment banks. LLP Founder and Stockbroker Fraud Attorney William Shepherd. says Bill Fleckenstein.
His inclusion in the offering document would not have changed opinions of those who were better established than him. Which side Paulson was taking should have been immaterial to ACA and other sophisticated investors as they would have done their own analysis regardless of the other parties' intentions.moneycentral. creates a consumer protection bureau at the Federal Reserve and bolsters oversight of derivatives and hedge funds. Paulson was a relatively unknown investor.htm Lehman Brothers "ABS Credit Default Swaps.crisis. Senator Blanche Lincoln. COMMON MAN¶S VIEW After reading the SEC's case and Goldman's Defense Document. Wallace "ABX. Boehner said in a statement after the SEC lawsuit was announced.This is another example of how risky Wall Street behavior puts our nation's financial system in peril and further illustrates the need for the strong reform.S. it had every incentive to select the appropriate securities.com/2010/04/16/goldman-sachs-fraud-expla_n_540938.com/article/SB10001424052702303491304575187920845670844.funded safety net by designating them too big to fail. Dodd s bill sets up a mechanism for unwinding systemically important financial firms when they fail. House Minority Leader John Boehner. These are very serious charges against a key supporter of President Obama s bill to create a permanent Wall Street bailout fund. which it did.html http://www. And even as our country is still recovering from those mistakes.com/Investing/ContrarianChronicles/goldman-deal-gamblersknew-the-score. Moreover. REFERENCES http://www. an Ohio Republican. The bill gives Goldman Sachs and other big Wall Street banks a perpetual. at that time.msn. Goldman is in the business of facilitating transactions for its clients and investors. I do not think the SEC would have filed a case against Goldman had the mortgage market not melted down.aspx?page=1 http://online. I feel that SEC's case is one that is aided by hindsight and is not strong enough. said the SEC suit provided further reason to oppose the measure.HE Indexed Credit Default Swaps and the Valuation of Subprime MBS" .sec. Having the largest exposure of $951 million. U.huffingtonpost.wsj. What went into the deal was the sole responsibility of ACA.A Primer" Richard Stanton and Nancy E.html http://articles.gov/news/press/2010/2010-59. Wall Street financial firms continue to game the system. taxpayer.
there is no assurance that such rating will not be reduced or withdrawn in the future. such status or non-public information in connection with the Transaction Goldman Sachs does not make any representation.RISK FACTORS Goldman Sachs may. . reasonableness or completeness of the information contained herein or in any further information. by virtue of its status as an underwriter. Although at the time of purchase. recommendation or warranty. advisor or otherwise. to disclose. the Reference Entities and/or other obligations of the Reference Entities and has not undertaken. express or implied. such Collateral will be highly rated. nor is a rating a guarantee of future performance. possess or have access to nonpublicly available information relating to the Reference Obligations. adequacy. regarding the accuracy. notice or other document which may at any time be supplied in connection with the Transaction and accepts no responsibility or liability therefore. and does not intend.
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