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Soros on Principles of Financial Regulation and Efficient Market Hypothesis:

George Soros has a very interesting opinion piece in the Financial Times, June 17, 2009 (might be behind subscriber wall at the FT, but I received it by email from his office, so I'll quote some bits from there). The essay outlines in short form his principles for reform of financial regulation. I am still absorbing this, so I won't comment here, but I put them out for your thoughts. I will try to post up some other stuff on the financial regulation reform proposals coming from the Obama administration over the next couple of days. (As ever, however, I am always eager to learn from what co-blogger Zywicki has to say about this stuff, and particularly the bankruptcy questions of Chrysler, GM, and Delphi - I am no expert by any stretch on sale v reorganization, or anything else, re bankruptcy. See Todd's earlier post comparing Chrysler, GM and the secured creditor treatment in each.)

So, Soros starts out with a general comment on the comparative disadvantages of un-regulation and government regulators:

I am not an advocate of too much regulation. Having gone too far in deregulating - which contributed to the current crisis - we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.

He then goes on to propose three guiding principles for regulatory reform. The first is that regulators must accept responsibility for not allowing bubbles to get out of control. This is framed within the inherent contradiction, Soros suggests, that regulators are no better than markets at identifying what's a bubble and what's not.

[S]ince markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes.

The implicit assumption here - correct, in my view - is that we have a problem of too-big-to-fail in these bubbles, systemic risk, and the loss of the threat of moral hazard: the Greenspan and next the Bernanke put. It is therefore not a sufficient answer for regulators to refuse to take on the burden of bubble-popping. This seems to me quite persuasive.

Second, Soros goes on, the problem is not merely the money supply, though that is a factor, it is also the availability of credit and then leverage off of it:

Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone - we must also use credit controls such as margin requirements and minimum capital requirements. Currently these tend to be fixed irrespective of the market's mood. Part of the authorities' job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.

Again, I think this is broadly persuasive. I say this despite being a big fan of John Taylor's new, short book from the Hoover Institution Press, Getting Off Track. The strong version of Taylor's argument, Steve Krasner noted to me in conversation last week at Stanford, is that if the Fed had simply followed the Taylor rule regarding the money supply, then the bubble would not have developed. On the strong version of Taylor's argument in the book, whatever the failures of regulation or, responding to Greenspan's reply to Taylor, the global savings glut, it doesn't matter - the money supply was the problem. Soros is implicitly saying that money supply alone is not the issue; credit and leverage matter on their own, and so does regulation directly going to credit, e.g., margin and capital requirements. Again, I am a big fan of Taylor's book - but I am content to read the argument more weakly, so to understand that the crisis is overdetermined, and that money supply, credit and leverage, political temptations in regulation, etc., all play a role. I think most financial commentators would go with the weaker position of overdetermination of causes. And on the credit question - more precisely, the leverage question - Soros is right, I think.

Soros finally - third - says that financial regulation must take up the question of efficient market theory. On this, he is most controversial. He has addressed much criticism toward the EMH over the years - and the arguments are not always the same, nor of the same level of breadth or generality. On the one hand, the latest edition of Bratton's Corporate Finance textbook, which I am about to use in the Fall semester for the first time in a couple of years and which begins with a discussion of efficient markets, expresses much greater caution, consistent with most academic commentators. Certainly that is my feeling, particularly with regard to credit markets and instruments. On the other hand, I was dismayed by how thoroughly my law students last year dismissed market efficiency as having any value at all and the very idea of quantitative valuation (of course, this would save them the trouble of doing the present value arithmetic ...). So what is Soros's formulation of the critique of EMH and how conceptually global is it in this iteration?

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.

The critique of efficient market theory here is agent-failure. No argument there - the agency problems go deep into the heart of the financial services institutions themselves, to include the fundamental problem of what Steve Schwarcz has described as secondary agent failures - misalignments of both duty of care and duty of loyalty. AT bottom, Soros is pointing to information uncertainties in two directions: one, as between managers and financial agents and, two, between compensation in the present on uncertain future payoffs, without an effective mechanism of clawback to correct results after the fact or an effective discounting mechanism to address potential future failure. But at bottom the critique in this piece of EMH is an agent-principal critique. One can add other critiques; some stronger and some weaker, but Soros has identified the one most amenable to regulatory reform, I reckon.

Given the agent-centered critique, it is no surprise that Soros favors a "skin in the game" approach - and he says that the 5% retention by originators in securitizations is too small:

To avert a repetition, the agents must have "skin in the game" but the five per cent proposed by the administration is more symbolic than substantive. I would consider ten per cent as the minimum requirement. To allow for possible discontinuities in markets securities held by banks should carry a higher risk rating than they do under the Basel Accords. Banks should pay for the implicit guarantee they enjoy by using less leverage and accepting restrictions on how they invest depositors' money; they should not be allowed to speculate for their own account with other people's money.

It is probably impractical to separate investment banking from commercial banking as the US did with the Glass Steagull Act of 1933. But there has to be an internal firewall that separates proprietary trading from commercial banking. Proprietary trading ought to be financed out of a bank's own capital. If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs.

Again, little argument from me that proprietary trading conceptually at least belongs in the hedge funds and private equity funds, whether that is practical today or not. Proprietary trading is not the only problem. I ordinarily teach a private equity course each year; it covers the industry as a whole, including venture capital, buy out funds of various kinds, etc., and I throw in little bit on hedge funds as they aren't really covered elsewhere in our curriculum. But I was troubled when last I taught the class in spring 2008 at a quote in a Henry Kaufmann article in the WSJ - I always talked as an academic about private equity serving to bring managerial efficiencies to public companies via buyouts and all sorts of jolly stuff. Whereas Kaufmann quoted a LBO fund manager as shrugging and saying, in paraphrase, we're just part of the big mechanism that takes money from the Fed and pours it into the housing markets and take a cut along the way. Ouch, ouch, double ouch.

And finally ... derivatives. Do not fail to note Soros's blunt comment on credit default swaps (italics added below). I am not sure I would have focused on CDSs, once having put them onto public exchanges and regularized and made public the counterparty relationships. Nor do I think that the underlying securitizations are themselves the problem. I grant the agency issues that Soros raises and of course there is a huge, huge problem with insurance that turns out to be a license to kill. The problem is more than just license to kill. It is also what we might call a "license to be indifferent" - arising from what has been talked about as the "phantom" creditor problem - formally holding debt the risks of which have already, but non-publicly or transparently, been counter-partied away, leaving one with an incentive to indifference or something more toxic. Moreover, the mere existence of an insurance market in CDSs does not, by itself alone, solve the valuation problem of the underlying assets or the insurance. Still, I think I probably would have instead focused on the derivatives built to leverage the securitizations themselves as being the most dangerous and toxic assets in all of this:

Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.

Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and thatof General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else's life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

Whether one agrees with Soros on each item, or the strength he assigns each item, this is an outstanding short essay on reform agendas. As I remarked in my note on the passing of Peter Bernstein, Soros on these issues of finance and political finance is in a category of senior, seasoned observer who is both at home with the analysis of risk but also very clear as to its limits, and rooted in the practical world of markets first and theory second. You can, as I do, think that Soros's funding for things like Moveon.org and other bitterly partisan political ventures a very bad thing - and I mean a very bad thing, and a very bad thing including for the Democratic Party, but that's a whole different discussion - while seeing the value in this kind of informed intervention. The financial crisis is a matter, unlike a range of others, that fits Soros's very considerable public talents hand to glove.

interruptus:
Thanks for the link and analysis. It's a pretty persuasive analysis, avoiding too much hyperbole or knee-jerk solutions, and trying to dig out what the trouble is.

I'd place it roughly in a category that's becoming strong in economics, which you might call something like the dynamical-systems-engineering view. That is, economies are dynamical systems that can be characterized at a macro-level by various summary information and modes of operation. Some but not all of those are systems that operate approximately like idealized economic theory predicts: efficient pricing, the "invisible hand" automatically adjusting supply and demand based on price signals to optimally allocate resources, etc.

This view shares some in common with the anti-market left that attacks the idealized theory for being out of touch with reality (i.e. is descriptively inadequate), but differs with them on the normative remedy (that therefore we ought to recognize that markets are broken and to a greater or lesser extent ditch them). The dynamical-systems-engineering view argues something like: but we really do want to live in a world governed by those idealized markets. Why don't they always come about naturally, and what can we do to improve that situation? The earliest stirrings of that were in Adam Smith, of course, who gave numerous warnings about ways in which the invisible hand could be stymied, e.g. by anti-competitive cartels. But the idea seems to be making a bit of a resurgence.
6.17.2009 3:37pm
byomtov (mail):
Interesting post.

When was the "phantom creditor" problem first widely recognized? It seems serious enough that, once it is understood, the CDS market might shrink a lot.
6.17.2009 3:41pm
Hans Bader (mail):
That's not the focus of President Obama's recent financial regulation proposals, which mandate even more risky loans to low-income borrowers by banks.

The President has just announced proposals for a massive overhaul of the financial system. The proposals would force banks to make even MORE risky loans to low-income people. Even liberal newspapers like the Village Voice have admitted that "affordable housing" mandates are a key reason for the housing crisis and the massive number of defaulting borrowers. But Obama will not accept this reality. Instead, he wants to create a new "Consumer Financial Protection Agency" to rigorously enforce regulations pressuring banks to make loans to low-income borrowers, such as the Community Reinvestment Act. (Obama once represented ACORN, which pressures banks to make risky loans).

In explaining why there is a need for this agency, when other agencies already enforce the Act and other fair-lending laws, his regulatory blue print complains that "State and federal bank supervisory agencies' primary mission is to ensure that financial institutions act prudently, a mission that, in appearance if not always in practice, often conflicts with their consumer protection responsibilities." (Pg. 54).

In other words, the power to force banks to make low-income loans should be given to an agency that has no duty to ensure prudent lending or to take into account the effects of such requirements on banks' stability or viability.

The President also wants to give financial regulators the power to seize key companies to prevent real or imagined "systemic risks" to the financial system. These are the same federal regulators who used the AIG bailout to give billions in unnecessary payments to Goldman Sachs, which neither needed nor expected that much money, and forced Freddie Mac to run up $30 billion in losses to bail out deadbeat mortgage borrowers. We are taking about the same federal government that took over Chrysler and General Motors, and then used them to rip off pension funds and taxpayers to enrich the UAW union.

(There is one good thing in the President's proposals, though: it gets rid of the inept Office of Thrift Supervision, which supervises savings and loans and failed to protect investors, and gives most of its responsibilities to the Office of Comptroller of the Currency, which competently supervises national banks.)

Obama's regulatory blue-print disingenuously claims that the Community Reinvestment Act, which pressures banks to make low-income loans, can't have contributed to the mortgage crisis, because it existed for years before the crisis began. But it is not the Act's passage on paper that economists credit with causing the mortgage crisis, but rather the stringent regulations adopted under the Act many years after the Act's passage. Those regulations went into effect not long before the mortgage bubble began, as historian Clayton Cramer notes. Economists, investment bankers, and historians have long noted the role of the Community Reinvestment Act and its regulations in promoting the risky lending that spawned the financial crisis. Investors Business Daily has chronicled how "the Community Reinvestment Act" pressured lenders to make the risky loans that led to the mortgage meltdown.

The current mortgage crisis came about in large part because of Clinton-era government pressure on lenders to make risky loans in order to make homeownership more affordable for lower-income Americans and those with a poor credit history, the Washington Examiner notes. "Those steps encouraged riskier mortgage lending by minimizing the role of credit histories in lending decisions, loosening required debt-to-equity ratios to allow borrowers to make small or even no down payments at all, and encouraging lenders the use of floating or adjustable interest-rate mortgages, including those with low 'teasers.'"

The liberal Village Voice previously chronicled how Clinton Administration housing secretary Andrew Cuomo helped spawn the mortgage crisis through his pressure on lenders to promote affordable housing and diversity. Andrew Cuomo, the youngest Housing and Urban Development secretary in history, made a series of decisions between 1997 and 2001 that gave birth to the country's current crisis. He took actions that in combination with many other factors helped plunge Fannie and Freddie into the subprime markets without putting in place the means to monitor their increasingly risky investments. He turned the Federal Housing Administration mortgage program into a sweetheart lender with sky-high loan ceilings and no money down . . . Three to four million families are now facing foreclosure, and Cuomo is one of the reasons why." (See Wayne Barrett, "Andrew Cuomo and Fannie and Freddie: How the Youngest Housing and Urban Development Secretary in History Gave Birth to the Mortgage Crisis," Village Voice, August 5, 2008).

In drafting his financial regulation proposals, Obama has turned to Barney Frank and Chris Dodd, lawmakers who are among those most culpable in spawning the financial crisis. The New York Times reports that "the plan is largely the product of extensive conversations between senior administration officials and top Democratic lawmakers — primarily Representative Barney Frank of Massachusetts and Senator Christopher J. Dodd of Connecticut." Frank and Dodd were the lawmakers whoy defeated reform proposals to rein in the government-sponsored mortgage giants, Fannie Mae and Freddie Mac, which later had to be bailed out for hundreds of billions of dollars. Fannie Mae killed reform proposals by paying off liberal lawmakers and bullying critics. Dodd recently attracted criticism for financial and ethical lapses.

Banks and mortgage companies have long been under pressure from lawmakers and regulators to give loans to people with bad credit, in order to provide "affordable housing" and promote "diversity." That played a key role in triggering the mortgage crisis, judging from a story last year in the New York Times.

For example, "a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers, according to a Congressional source." The executives of government-backed mortgage giants Fannie Mae and Freddie Mac "eventually yielded to those pressures, effectively wagering that if things got too bad, the government would bail them out." But they realized the risk: "In 2004, Freddie Mac warned regulators that affordable housing goals could force the company to buy riskier loans." Ultimately, though, Freddie Mac's CEO, Richard F. Syron, told colleagues that "we couldn't afford to say no to anyone."

As a Washington Post story shows, the high-risk loans that led to the mortgage crisis were the product of regulatory pressure, not a lack of regulation. In 2004, even after banking officials "warned that subprime lenders were saddling borrowers with mortgages they could not afford, the U.S. Department of Housing and Urban Development helped fuel more of that risky lending. Eager to put more low-income and minority families into their own homes, the agency required that two government-chartered mortgage finance firms purchase far more 'affordable' loans made to these borrowers. HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing."

Lenders also face the risk of being sued for discrimination if they fail to make loans to people with bad credit, which often has a racially-disparate impact (proving that such impact is unintentional is costly and difficult, and not always sufficient to avoid liability under antidiscrimination laws). They also risk possible sanctions under the Community Reinvestment Act.

Banks get sued for discrimination no matter what they do. If they don't make enough loans in low-income, predominantly minority neighborhoods, they get accused of "redlining," and are subject to sanctions under politically-correct laws like the Community Reinvestment Act, which contributed to the financial crisis by pressuring lenders to make risky mortgage loans.

But if they do make such loans, they get accused of "reverse redlining," and get sued by the liberal special-interest groups and municipalities that encouraged them to make such loans during the mortgage bubble. Baltimore and various borrowers have also brought “reverse redlining" lawsuits against banks.

The Washington Post reported that bond-rating agencies like Moody's and Fitch are now getting sued, too, for "reverse redlining," under the theory that they encouraged risky loans to low-income minorities (who subsequently regretted taking out those loans) by giving respectable ratings to the mortgage-backed securities produced by packaging those mortgage loans. The plaintiffs include the National Community Reinvestment Coalition, which has been pressuring lenders to make risky loans to low-income minorities for years. They blame the ratings-agencies for allowing lenders to make loans to minorities with insufficient borrower income levels."
6.17.2009 3:59pm
interruptus:
Hans Bader: Although the CRA may have had a role in the troubles of retail lenders, a single-minded focus on it doesn't seem like it can explain the size and depth of the financial-market failure. Even if retail lenders were required to issue risky loans, there was no such requirement for anyone else to purchase them, securitize them, purchase the securitized versions, purchase or sell credit-default swaps on them, etc. Had they not done so, and it were just retail lenders suffering losses for having made bad loans, the contagion would not have been particularly widespread.

Presumably the institutions who did all those things did them willingly, and ought, if the financial system was working properly, to have priced them appropriately and set aside appropriate amounts of capital to manage the default risk. If indeed the CRA required retail lenders to make bad loans, purchasers of those loans, or securitized versions of them, ought to have acted accordingly. It appears they did not, which is not a failure that can be blamed on the CRA: why trillions of dollars in poorly priced and poorly accounted-for securities and derivatives were issued and held, by companies that empirically turned out to be unable to manage the risk they entailed, is a question about market failure.
6.17.2009 4:12pm
Anderson (mail):
Thanks for the press release, Hans.
6.17.2009 4:21pm
byomtov (mail):
As a Washington Post story shows, the high-risk loans that led to the mortgage crisis were the product of regulatory pressure, not a lack of regulation.

It really is bad form to cite yourself as an authority in support of an argument.

And of course, as interruptus points out, mortgage problems were caused not so much by bad loans as by their mispricing in the secondary markets, which included lots of very big private players.
6.17.2009 4:28pm
John Jenkins (mail):
"Having gone too far in deregulating - which contributed to the current crisis - we must resist the temptation to go too far in the opposite direction."

Can anyone point to an instance of deregulation that contributed to the asset bubble? It has been common for people to say that the repeal of Glass-Steagall restrictions on combining commercial and investment banking contributed, but no one can seriously believe that (and I have not read about any mechanism for that repeal to have any such effect), so how do we credit an analysis on an unproven (and I believe false) premise?

We have a deeply regulated financial industry. It's clear that some of the people involved figured out a way to game the regulations, but that will always happen and is unrelated to deregulation.
6.17.2009 4:33pm
Desiderius:
In general, another outstanding post. One question:

"some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else's life and owning a licence to kill him."

Given the means by which Soros made much of his considerable fortune, is this a case of the hacker switching sides?
6.17.2009 4:45pm
Bill Sommerfeld (www):
The life insurance analogy for CDS only goes so far.

There was a recent incident where CDS buyers betting on what seemed to be a near-sure default wound up losing their bets when it turned out that the CDS writer had collected far more in CDS premiums than was necessary to prevent the protected bond from defaulting -- so they just "altruistically" paid off the bonds and pocketed the balance of the premiums, instead of having to pay out 4-5 times the face value of the bonds on a default.

see: http://online.wsj.com/article/SB124468148614104619.html
(not sure if this is behind the paywall or not).
6.17.2009 4:56pm
luagha:
We had plenty of regulators telling us what was wrong and telling us what to do. The problem was that they were trumped by political power. The solution is not hiring more regulators to ignore. Nor is it hiring political regulators who will regulate based on politics and not reality - that is what we ended up doing before.
6.17.2009 5:02pm
luagha:
And as for Soros, I haven't read this particular essay, but I did read one of his earlier public essays about this crisis.

The disconnect was remarkable. It had a concise explanation of exactly what was going on and what was going wrong. And then the solution was basically, "Become socialists under the control of rich liberal elites."
6.17.2009 5:06pm
Andrew J. Lazarus (mail):
Reading interruptus on Bader is a little like seeing smallpox vaccination compete with pagan anti-smallpox sacrifices.
6.17.2009 5:12pm
geokstr (mail):

byomtov:
And of course, as interruptus points out, mortgage problems were caused not so much by bad loans as by their mispricing in the secondary markets, which included lots of very big private players.

Oh, gosh, I didn't realize that the "...mispricing of bad loans in the secondary markets..." caused millions of the borrowers to default. Amazing how those secondary markets can force their problems backwards and downwards onto the little guys, who signed those 100-110% subprime loans with the teaser rates through no fault of their own, causing them all to default on their mortgages.

The left will never, ever, in a billion years, admit that the underlying principle of their Marxist philosophy, spreading the wealth, and the homeownership, around, was in the slightest degree responsible for any of the financial meltdown whatsoever. No sirree, it was those capitalist-roader greedy rightwingers, all the way.
6.17.2009 5:23pm
Anderson (mail):
admit that the underlying principle of their Marxist philosophy

Got a citation to a particular page of Marx's works? Or just tossing "Marxist philosophy" around as a pejorative?

I don't think "spreading the wealth around" is exactly communist doctrine.
6.17.2009 5:45pm
Andrew J. Lazarus (mail):
Geokstr, if you bothered to read, the idea is that without securitization it would have been much less damaging when those borrowers defaulted. You can deny that, if you have some reasons to present, but you can't really refute that claim by referring to the original defaults.

Would you like to try again, or is your keyboard stuck on snark?
6.17.2009 6:02pm
George Smith:
CRA loans by regulated banks were not THE cause, just one of the causes of the mortgage melt down. Far more subprime loans were made by private mortgage companies, who mde them because they could sell them the Fan/Fred, which were told by Congress to buy them, and then shielded from scrutiny. The mortgage bankers and brokers with whom I work call this the D/F/R mortgage crisis - Dodd/Frank/Raines. And no, the borrowers are not victims; they knew their rates would reset to market, as their notes plainly said. The defaults are not coming from low income borrowers who bought houses commensurate with their incomes. The defaults are coming from borrowers who took out loans for far more than they had any prayer of repaying at market rates.
6.17.2009 6:04pm
Cody (mail):
I think Soros' argument here has two main problems.

First, while agency problems were no doubt one factor, much of the crisis appears to have been unrelated. The core issue was not that most major market participants felt that the instruments they were selling were crap but were happy to sell them on to gullable fools anyhow. Rather, the core issue was that those major market partcipants were the gullible fools. At a first aproximation Lehman Brothers failed because they actually thought the toxic sludge they were dealing in was a great investment, and kept too much of it on their books. Soros would have us believe the solution to this is a rule that forces people to do exactly what led to so much of the crisis? I think not.

In short, it may be a great idea on its own merits, but the "skin in the game" rule wouldn't have prevented the crisis. It is a rule which would work well if people understand what's going on, and just need to be kept honest. With a couple of fairly minor exceptions, that doesn't appear to be what happened. Once you get beyond the mortgage brokers, most participants were honest, but foolish. (Including Soros, who lost heavily as a result. A cynic might suggest that explains why Soros is now suggesting solutions to non-existent problems: facing the actual problems would be too painful for a man as invested in his own omniscience as Soros...)

Second, Soros has a well-known phobia for CDS, but he long ago squandered whatever credibility he may have had on the topic through basic errors and blatant lies.

Further, his arguments - as presented here - are as unpersuasive as ever. He argues by analogies which fall apart on even cursory examination.
6.17.2009 6:12pm
byomtov (mail):
geokstr,

You can buy all the lousy loans you want and not get in trouble if you pay the right price. In other words, if you have a good estimate of default rates you will pay a low enough price to come out ahead despite many loans defaulting.

Similarly, you can buy a bunch of excellent mortgages - 20% down, borrowers with great credit, etc. - and if you pay too much, and especially if you use a lot of leverage - you are going to be in deep trouble.

Rant about marx, etc. all you want to. I'm sure it saves you a lot of thinking.
6.17.2009 6:44pm
SenatorX (mail):
This is framed within the inherent contradiction, Soros suggests, that regulators are no better than markets at identifying what's a bubble and what's not.

If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes.

Isn't this just flawed thinking though? He was more accurate with: "While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum."

But then he jumped ship on his logic. Why exactly are markets no better than regulators at identifying bubbles? Are there no feedback loops that can be created to replace flawed and influenced regulators? We know why the rule of law is better than the rule of man and yet even though he stares it in the face he still chooses the wrong path. I wonder why that is?
6.17.2009 6:57pm
Specast:
Thanks very much for this analysis, especially for making it accessible to readers like me who are not well-versed in these subjects.

One suggestion: for long posts such as this, please use the "show rest of post" function to hide most of the post. Makes is much easier for VC visitors to skip past the posts they're not interested in.
6.17.2009 6:59pm
Desiderius:
Anderson,

"I don't think "spreading the wealth around" is exactly communist doctrine."

Nope, just Huey Long. Not sure that's much of an improvement. To be fair, neither applies particularly well to Obama. His most fervent supporters? Significantly more so.
6.17.2009 7:40pm
Careless:


You can buy all the lousy loans you want and not get in trouble if you pay the right price. In other words, if you have a good estimate of default rates you will pay a low enough price to come out ahead despite many loans defaulting.

It's remarkable how badly the rating agencies screwed the pooch on the whole deal, and then how blindly people followed them
6.17.2009 7:47pm
Kenneth Anderson:
Specast - good idea.
6.17.2009 7:49pm
RPT (mail):
"Anderson:

Thanks for the press release, Hans."

I agree. Both HB and 24.com use this site to dump their own already "published" and self-cited works. Talk about the cheetos guys in their shorts......
6.17.2009 8:46pm
byomtov (mail):
It's remarkable how badly the rating agencies screwed the pooch on the whole deal, and then how blindly people followed them

They certainly screwed the pooch. Whether that was remarkable or not is a different question.
6.17.2009 8:51pm
Tatil:

Far more subprime loans were made by private mortgage companies, who mde them because they could sell them the Fan/Fred,

I am not sure. Isn't subprime by definition the kind of mortgage Frannie and Freddie do not buy?

I know there is huge need to blame politicians for many people for all of this, but bubbles do form and markets do fail from time to time even without the government. When too many people believe the value of an investment, a bubble will form by creating an irresistible short term gain opportunity. Everybody assumes they can get off the train on time, but of course, most will be too late. JP Morgan got off on time, Bear Stearns did not.
6.17.2009 9:34pm
rosetta's stones:

"I know there is huge need to blame politicians for many people for all of this, but bubbles do form and markets do fail from time to time even without the government."


Fine, since you don't want to blame anybody, let's just talk about what happened and see if we can find somebody to blame.

My sister-in-law took out a mortgage a couple years ago, which is now in foreclosure. It was a pure liar loan, because I know her income and cash flow, and nobody should have written it, let alone with a teaser rate and accelerator and 125% loan to value or whatever nonsense was in there (including a bogus appraisal, no doubt).

That loan had to be sold to somebody, and that somebody had to know that the stack of loans they were buying contained a % of liar loans. But, they'd have no way of knowing how many. Right then, the uncertainty was introduced into the mainline investment world.

Should we start waterboarding those who introduced those stacks of loans, those who bought them, those who were supposed to be regulating the quality and character of the loans in the stack, those who created the default swaps designed to manage the risk introduced by the stack... who do we waterboard?

Or should we just waterboard everybody?

Is there even enough water available to get the job done properly here?

I'm sorry, but "bubbles just happen" doesn't do it for me. I want names. I want accountability. This is costing me plenty.

Let's start with Soros. We should waterboard him just on general principles. And, KA, you need to add at least another 250 words to your Soros disclaimer at the end of your post... maybe break it into 2 or 3 paragraphs so we know you really mean it. ;-)
6.17.2009 9:54pm
EPluribusMoney (mail):
It's remarkable how badly the rating agencies screwed the pooch on the whole deal, and then how blindly people followed them

Aren't all the major players required to use one of 3 rating companies? And I heard that each rating agency gave top ratings because the issuers would go to the other two and they'd lose business. Now if the law didn't require these three then the buyers might have required a independent look at the books.

It all comes down to too much regulation again, not too little.
6.17.2009 9:56pm
ArthurKirkland:
Does anyone know whether Mr. Bader is compensated by the word or, instead, by the link?
6.17.2009 10:01pm
Desiderius:
KA,

"On the other hand, I was dismayed by how thoroughly my law students last year dismissed market efficiency as having any value at all and the very idea of quantitative valuation"

Care to expand upon this a bit for our Progressive friends who don't believe that the Che t-shirt wearers are aware what they are about?
6.17.2009 10:10pm
hospis (mail):
Although Blogger concedes his ignorance of Private Equity's game, he still insists on estimating the game of CDS traded OTC. Trading CDS OTC is not only cause of indifference for buyers but more so is a motive for trading assets at prices far away from those estimated by any economic theory. Assume a company XYZ with market cap of $10MM; if banks MER BSC LEH GS MS each recklessly offered to sell me call options with strike $10 and notional value $1MM, I'd have a motive for buying every share at any price regardless of sales or earnings; in fact, I'd have a motive to push the price higher by buying the fewest shares, which opposes directly what any buyer without calls would do (buyers usually attempt to buy as many shares as possible with the least move up in price).
6.17.2009 11:34pm
Pooblicus:
I wouldn't want to claim to have the financial background of Soros, but I have tried to understand the financial meltdown as best a dumb county boy can.

It seems to me that there are two issues that drove this. The first is at least addressed in Soros's and other other commentators analysis. It is that the market allowed players to place bets that would pay them well if they bet right, but that they could not hope to pay if they lost badly.

The credit risk swaps were a classic example. It is very clear in retrospect that collectively this market could not come even close to paying the bill when the mortgage market went significantly toxic. But they pocketed handsome profits for selling them, and would have done even better if business had been kind enough to continue "as usual."

In a former life I knew some professional risk-takers who used decks of 52 cards, back before such folks became cool. There were serious men, not necessarily nice fellows you would want to introduce to your mother. I remember asking them if stakes were always placed in cash before big games. They said that in big games like the big meets in Vegas they were, but generally in private games they were not. You could bet as you pleased. But if you lost and couldn't pay either on the spot or very quickly, you were simply killed. Kept the game reasonably honest by their perspective.

This would probably work in the credit markets, but I don't think this is the regulation our dear leader has in mind.

The issue can be addressed in a more civilized manner by requiring that ability to pay be demonstrated before pushing the chips forward, either in cards or finance. I am frankly baffled as to how this could be done in the great world of finance, but if regulations are needed, this could be the approach that would do some good, or at least the smallest harm.

Simply being able to show certain financial worth to participate would not have worked in the recent fiasco. Many of the players would have looked very good on paper, AIG being the poster child here. The requirement would have had to include worth to cover bets even if the world really did go to hades in a handbasket. Possibly a multiple ratio of worth in conservatively valued securities, cash or cash equivalents, or other valuta. I am glad I am not asked to create the boilerplate for this, but I think the concept is sound.

This would of course limit the returns on capital invested in this type of product. But it would not prevent it being issued if it is needed. It would prevent it from being viewed as a license to print money. And limiting it to normal prudent returns would have prevented it from growing trendily into the monster it became. (as a sidebar, the concept that you can insure away all financial risk is a fools errand that only looks good if you don't look at it too closely)

The other issue that is being proffered by our dear leader is whether a change is needed to prevent any entities from being "too big to fail." Frankly I have some sympathy for his viewpoint here. If failure is not allowed, we do not have a capitalist system. We have a public lottery, with the big players allowed to call the numbers. Again, they would have happily banked the profits if they had won, but they couldn't pay the piper when they lost.

So the solution could be to require progressively tighter capital requirements as units got larger. At some point the equilibrium point between economies of scale and lower ROI would make companies reach terminal size well before they got so large that they risked the stability of the market.

These ideas would not require the government poking nosily into every corner of our business. They would simply create parameters that would keep the greed focused into productive enterprises.
6.18.2009 12:33am
Ricardo (mail):
Second, Soros has a well-known phobia for CDS, but he long ago squandered whatever credibility he may have had on the topic through basic errors and blatant lies.

The "blatant lie" appears to be, based on the link you provided, that Soros says credit default swaps carry unlimited profit opportunities. Nobody would take this literally, though. Yes, profit opportunity is limited to the notional value of the swap but notional value of all outstanding CDSs was $38.6 trillion at the end of 2008. This is a huge number even by the standards of finance and the notional value exceeds the value of the real assets that CDSs are supposed to be insuring.

That surely is the problem. The creation of "synthetic assets" via the CDS market helps market participants to achieve absurd leverage ratios.
6.18.2009 12:46am
Allan Walstad (mail):
So let's see--the Fed drives down interest rates toward zero, people engage in rampant speculation with the resulting cheap money, pols pressure banks to make bad loans, Freddie and Fannie play their reckless roles with everyone knowing the feds would prop them up--and somehow the resulting problems are due to insufficient government regulation of markets? This is just one more wretched example of the same old cycle: government intervention in the market causes problems that are blamed on the market and become the excuse for more government intervention, etc.

Banks are too big to fail? Nonsense. The assets are still there, the buildings are still there, the people with specialized skills are still there. Bankruptcy means the assets are purchased at sufficiently low price so that the new owner can afford to sort out the wheat from the chaff and profit from the former. Loans can be renegotiated. All the normal market processes are short-circuited by pols and bureaucrats whose ignorance is exceeded only by their hubris.

And now we have Obama and Bernanke thinking to bring back prosperity via pork on a cosmic scale, financed by dollars printed out of thin air or borrowed from our Chinese buddies. An various other competing economic astrologers gravely casting their horoscopes.

This is a regulatory failure all right--the failure of the courts to enforce the Constitutional limitations regulating federal activity.
6.18.2009 1:39am
MikeS (mail):

Moveon.org and other bitterly partisan political ventures


This is a joke, right? Or does any liberal/Democratic organization that says anything more than "Please sir, may I have another?" count as bitterly partisan?


"He has no credibility left." -- Sen. John Ensign (R-NV), quoted by the Las Vegas Sun in 1998, urging Bill Clinton to resign after he admitted an extramarital affair.
6.18.2009 1:50am
Ricardo (mail):
Re: Government regulation

Here's a simplified version of what investment banks did. You borrow at LIBOR + x% in order to buy AAA-rated senior tranches of CDOs heavily invested in mortgage-backed securities that yield an average of LIBOR + y%. Then you buy a credit default swap that insures you against a default on a basket of mortgaged-backed securities similar to the ones you are exposed to. The amount you pay is a percentage of the notional value that we will call z%. Let's assume the notional value of the swap is the same as the value of all CDOs the bank has on its books.

Your return on assets in this trade is then y% - x% - z%. This might be about 0.2% which means you have to lever yourself to the hilt and wave away any mention of counterparty risk in order to make any respectable return on equity.

Can someone point to the government regulation that required Lehman Brothers, Bear Stearns and the like to do this?
6.18.2009 2:31am
rosetta's stones:

"Banks are too big to fail? Nonsense. The assets are still there, the buildings are still there, the people with specialized skills are still there. Bankruptcy means the assets are purchased at sufficiently low price so that the new owner can afford to sort out the wheat from the chaff and profit from the former. Loans can be renegotiated. All the normal market processes are short-circuited by pols and bureaucrats whose ignorance is exceeded only by their hubris.

And now we have Obama and Bernanke thinking to bring back prosperity via pork on a cosmic scale, financed by dollars printed out of thin air or borrowed from our Chinese buddies. An various other competing economic astrologers gravely casting their horoscopes.

This is a regulatory failure all right--the failure of the courts to enforce the Constitutional limitations regulating federal activity."



We should all reread this excerpt from Walstad's post above, because it describes the situation clearly.

Most of us are making our payments. That cash has to go somewhere, and will. The government, rather than focusing on those good assets, and seeing that they went over to still solvent companies, decided some banks were too big to fail. Yes, there would have been carnage, but would it have truly been worse than what we're experiencing right now?

If the government is going to print money, then find a way to distribute it to the hundreds and hudreds of community banks... not Paulsen's WS buddies.
6.18.2009 9:39am
PLR:
This is a regulatory failure all right--the failure of the courts to enforce the Constitutional limitations regulating federal activity.

Personally, I view the Constitution's relevance to the regulation of financial markets to be roughly analogous to the Old Testament's relevance to determining the age of the physical universe.
6.18.2009 10:56am
wht (mail):

Can anyone point to an instance of deregulation that contributed to the asset bubble? It has been common for people to say that the repeal of Glass-Steagall restrictions on combining commercial and investment banking contributed, but no one can seriously believe that (and I have not read about any mechanism for that repeal to have any such effect), so how do we credit an analysis on an unproven (and I believe false) premise?

The provisions exempting certain derivatives from any regulatory oversight is a pretty big one. The lack on regulations on what amounted to trillions of dollars.

You also have the former adminstration pre-empting state AG's trying to crack down on fraudulent practices by large subprime lenders by claiming that the office of comptroller of the currency is responsible for regulating these entites, and states have no say. This started happening in about 2004. The comptroller never had and was never given any resources to actually do what it was preventing the states from doing by pre-emption. It was a defacto deregulation of large swaths of the subprime mortgage business.

Pretty much mirrors the softening of regulation of S&L's in the 80's. Less regulation = larger pools of money being involved and more gimmicking practices emerge along with more outright frauds as people begin to try and game the system.

There is no one person to blame here - but more of the blame falls on the banks. Starting with using valuation equations that every math expert (that did not work for them and even some that did) was not suitable for the valuation of mortagages. Reliance on this formula led to a conclusion that based on past markes these securites were safe (less the .06% risk). Every bank used these and they shouldnt had. A few people crunched the numbers and even if you accepted that slight risk, in about 2006 the amont that could be lost if the risk mataterialized could not be sustained. Basically everyone put every sinlge bet on the same horse, and every single person borrowed to do so. Its basically the equivalent of taking everything you own, then borrowing about 100x that much and than placing it all on a guaranteed winner, than loosing. Now you cant pay. Thats terrible for the house. In this case the house took out insurance in case you couldnt pay. The people making the insurance ran the numbers through the same equation as the house and the gambler and came to the same conclusion that this is a certainty. No government agency ever told them this was a great idea.



Dont believe the hype that subprime was fueled by freddien and fannie. It was fueled by good old capitalism. Softening regulation and higer returns by huge multiples. Nearly all the subprimes were picked up the big banks. It doesnt take a genious to figure out why either. Most were not even eligible to be picked up by freddie and fannie, but if you ran any bunch or even tranches through the equation these things looked like money printing machines. Everyone wanted most of these loans, any mortagage guy telling you these things were forced on him by washington is either delusional about their own part in, or just plain lying. Nobody wanted this to stop, not freddie or fannie, not the big banks, not the retail lenders, not the washington politician and certainly not local and state politicians who saw rising property values fueling increased budgets.

And Lehman's biggest losses were on commercial real estate, dont see how you can blame anyone but the bankers on that one. They took on risk, borrowed to do, and were wrong.

The biggest problem that still exists is that these banks are still just too big. This system doesnt work. More regulation can help, but the best solution is to undo the constriction of this market over the last 20 years. There should be 20 big investment banks, a hundred or so large commercial. This is how capitalism is suppose to works, lots of competition creates a better more efficient market (never perfectly efficent, but better). Too big too fail is a systemic problem that needs to be fixed. The repeal of Glass Seagal is part of the problem with the too big too fail group. They are basically too involved in too many areas. That was one the purpose of the law to begin with, isolate problems with individual institutions to certain areas of the finance, and hopefully it will prevent full fledge meltdowns.
6.18.2009 11:56am
byomtov (mail):
Banks are too big to fail? Nonsense. The assets are still there,..

Banks are not factories.

Bank assets are chiefly loans. When the loans go into default they are not in fact there. Sure, someone can buy them and try to ferret out the few good loans, but that won't be enough to meet the banks' debts, which can cause a cascade of failures.

Loans can be renegotiated. All the normal market processes are short-circuited by pols and bureaucrats whose ignorance is exceeded only by their hubris.

They can't be renegotiated if they have been split up into a hundred pieces, and the owners have conflicting interests. This is especially so if no one thought this could happen (See "models that didn't allow the possibility of housing price drops") and so made no provision for renegotiation. Talk about hubris. The hubris here was in the banks and investmenbt companies and the model-builders - not the government.
6.18.2009 11:59am
Dan7:
Re "skin in the game":

Yes, originators should have a stake in the outcome of a loan.


But the problem with Soros' and Anderson's argument is that requiring a bank to have skin in the game won't help. The individual loan officers who make the loans get bonuses based on how many loans they make. Then they leave their jobs 2 years later, and 3 years after that the 5-year ARM they sold becomes toxic. How do we get the individuals selling loans to have skin in the game?


One might argue that the banks, once they have a stake in the loan, will figure out how to pass on that responsibility to loan officers: but how? To me, this is a fundamental problem with credit in general: the individuals who extend the credit will not necessarily be around to see it come due.
6.18.2009 12:31pm
interruptus:

The individual loan officers who make the loans get bonuses based on how many loans they make. Then they leave their jobs 2 years later, and 3 years after that the 5-year ARM they sold becomes toxic. How do we get the individuals selling loans to have skin in the game?

One proposal is some way to effectively give "negative bonuses", to correct the asymmetry problem of a $0 floor that rewards taking volatile strategies. Obviously there are practical problems with actually just making the scale symmetric and assessing negative-$50,000 bonuses in years when a trader really screws up, but a practical solution is to make bonuses conditionally vest after some horizon, e.g. 5 years, which effectively takes them back if they screw up.
6.18.2009 2:56pm
Leo Marvin (mail):
Rosetta's

Yes, there would have been carnage, but would it have truly been worse than what we're experiencing right now?

Well, that's the question, isn't it? The economists charged with answering it in two administrations, one Republican, one Democratic, believe it would have been. Being the credulous sort, I take their word for it. But next time we pass a worm hole, jump in, go to last summer in a parallel universe, derail TARP, come back and let us know what happened.
6.18.2009 6:48pm
rosetta's stones:
Oh come on now, Leo, let's not take the cloistered few of Bernanke, Paulsen or their past clones Greenspan and Rubin as proof of anything. They are cut of the same bolt of cloth... regardless of which political party ostensibly annoints them. They run with the crowd who got bailed out.

And, you know very well that there was significant political opposition to that original TARP bill, and it only increased after that initial approval... and when the second 1/2 of the cash came up for approval, it nearly went down. Many are unconvinced of what you seem convinced. Look around.
6.18.2009 7:24pm
Cody (mail):
Ricardo wrote:
The "blatant lie" appears to be, based on the link you provided, that Soros says credit default swaps carry unlimited profit opportunities. Nobody would take this literally, though. Yes, profit opportunity is limited to the notional value of the swap but notional value of all outstanding CDSs was $38.6 trillion at the end of 2008. This is a huge number even by the standards of finance and the notional value exceeds the value of the real assets that CDSs are supposed to be insuring.
No. Soros's entire argument in the column I linked is based on the following claims:

1) "...there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long [on stocks] has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse."

2) "...the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks."

He's quite right about the first point, but he is completely wrong about the second point. The asymmetry he is discussing simply does not exist in the CDS market. It is, instead, absolutely symmetrical. Soros is saying that asymmetry is bad, CDS contracts have asymmetry, therefore CDS contracts are bad. But if CDS contracts have no asymmetry, where does that leave Soros' argument?

I admire the imagination you show in claiming that when Soros is talking about "asymmetry in risk/reward ratios" he was speaking figuratively and actually meant "the precise symmetry in risk/reward ratios", and that when he says "unlimited risks" he meant "absolutely known and finite risks". But if we accept your claims, then Soros is refuting his own arguments, since the entire column was based completely on the idea that the risks were asymmetric and that the risks were unlimited.

Since Soros goes to such lengths to attack CDS contracts, we can probably rule out that he's actually arguing in favor of them. So: does Soros have no idea how CDS contracts work, or does he just hope his reader's won't? Either way, it destroys his credibility.
6.18.2009 7:45pm
Leo Marvin (mail):
Rosetta's

Many are unconvinced of what you seem convinced.

I'm not convinced of anything. I just don't assume everyone I don't know personally is motivated by his basest self-interest.
6.19.2009 12:52am
rosetta's stones:

Being the credulous sort, I take their word for it.



You make this statement, and then you claim not to be "convinced of anything"?

I don't "assume" anything, I look at what happened, and is happening, and don't ramble on about "wormholes" and "parallel universes".
6.19.2009 10:15am
Leo Marvin (mail):
rs,

You make this statement, and then you claim not to be "convinced of anything"?

Taking someone's word for something isn't the same as being convinced of it.

I look at what happened, and is happening, and don't ramble on about "wormholes" and "parallel universes".

Then maybe you ought to try it.
6.19.2009 8:55pm
rosetta's stones:
Hmmm, you're not "convinced", but you're willing to ridicule one side of the discussion?

Tell me, does any of this depend on what one's definition of the word "is" is?

You're being obtuse, Leo. Fine to walk back the cat, and yes, your original wormhole post was ridiculous and required some catwalking, but best to unleash the cat and let it go now.
6.20.2009 10:12am
Leo Marvin (mail):
rosetta's,

I'm not walking anything back. If I'm being obtuse, I'm too obtuse to see it, so maybe you should explain it to me slowly. As for my wormhole post, it wasn't ridiculous. It was a farcical way of saying how easy it is to Monday morning quarterback when we'll never know the catastrophic extent of what was averted. If what you mean is that I was being snarky, then I'll plead guilty, but I honestly didn't think you would care.
6.20.2009 5:23pm
rosetta's stones:

"As for my wormhole post, it wasn't ridiculous. It was a farcical way of saying how easy it is to Monday morning quarterback when we'll never know the catastrophic extent of what was averted."


Hmmmmmm, so let's review, you were first convinced, then you became "not convinced", and then evolved to not just "taking someone's word for something", and have now regressed to saying that we'll never know what might have happened if we'd taken another path.

You're wearing that poor cat out, Leo.

Well, the cat may be fully fatigued, but it appears you and it have finally arrived at the true state of affairs, and it didn't take any wormholes to get there.

You don't know, you have an opinion, just as the opposition to the current actions had/have one, and we'll never know how much money and trouble they might have saved us, will we?

So well done, you and the cat seem to have arrived back at my original question, the one you wormholed:


"Yes, there would have been carnage, but would it have truly been worse than what we're experiencing right now?"
6.20.2009 7:38pm
Leo Marvin (mail):
Rosettas,

You packed so many distortions and outright misstatements of what I said into so few words I had to grab my head to see if it was actually spinning. That's too far from good faith debate to warrant unraveling. I'm done.
6.20.2009 8:03pm
rosetta's stones:
Come on, Leo, don't act abused here. You just made a flippant post, and I decided to step on you a bit, that's all.

You seem to be back to reality now, and the flippancy seems to have slipped away, and we can ponder the original question posed. That's sorta how this works, unless somebody thinks questions aren't necessary, and starts yammering about wormholes and such.
6.20.2009 8:59pm

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