Ralph Liu's clever idea: SwapRent

Posted by: Peter Coy on October 11, 2007

Ralph Liu.jpgDerivatives traders fueled the overlending of the housing boom by demanding huge volumes of mortgage-backed securities and their offshoots, few questions asked. But that doesn’t mean derivatives are all bad. In fact, a leading designer of derivatives has come up with a plan that he says would actually protect homeowners from the market’s crazy swings. And he may even be right.

The inventor is Ralph Y. Liu, a Taiwanese-born American entrepreneur in Corona, Calif. Liu worked on Wall Street for years, and most recently pioneered the first yuan-denominated interest-rate swap for domestic Chinese banks, which is a big deal. (Here’s a link to a Wall Street Journal story about that exploit.) The point is, Liu is the real thing.

Liu’s idea is to create derivatives that would let people continue to live in their houses, and keep legal ownership to them, without being exposed to fluctuations in the home’s value. He sees two sets of customers:

--Poor people who are in danger of losing their homes because they can't pay the mortgage could offer to surrender the upside potential in the home's price. An investor who wanted to gamble that the house will rise in value would pay a certain monthly amount to the homeowner, who would then be able to afford the mortgage.

--Rich people who want to be protected against the risk that the value of their homes will fall. These people, who presumably have the spare cash to buy a kind of price insurance, would pay a certain monthly amount to an investor (aka speculator), who would take on the risk of a decline in the house's value.

You could also buy a product that would work both ways--taking away your upside potential while simultaneously taking away your downside risk. The beauty? You'd still have legal title to the house, and when the contract expires after one, two, five years or more, everything would go back to the status quo ante.

I spent more than two hours on the phone with Mr. Liu to figure this one out, so I'm just scratching the surface here. For more, check out SwapRent.com.

The closest thing to Liu's SwapRent is a sale-leaseback arrangement. That's where you sell your house and then lease it back from your new landlord, with an option to repurchase it later. But in a sale-leaseback you actually lose title to the property. Sale-leasebacks have been used fraudulently in "foreclosure rescue" scams where the scammers boot out the previous owners and resell the house, grabbing whatever equity they can. That's not an issue with Liu's SwapRent.

Another cousin of SwapRent is the shared-appreciation mortgage, which has run into bad publicity in Britain. There, the homeowner gets a lower rate on a mortgage loan in return for giving the lender a portion of the appreciation on the home when it's sold. Trouble is, if you give up too much of the appreciation, and housing prices have shot up, you don't have enough cash left after the sale to buy another house.

Liu hasn't completely solved that sticky problem. Let's say you agree to give up the entire upside on your house. Under Liu's system, if the value goes up by $200,000 by the end of the contract, then your bank will pay $200,000 to the investor and simultaneously increase your indebtedness by the same amount. That means your monthly payments go up. If you can't afford them, you could end up losing the house. Then again, if you did this deal in the first place, it's because you feared losing the house earlier anyway.

You might be wondering who decides how much value the house has gained or lost when it comes time to settle the contract. Liu wants to base the house's change in value on the movement of a price index, such as those developed by S&P Case-Shiller, or Radar Logic, or Dataquick. Advantages: No bickering over appraisals. And no "moral hazard"--i.e., the risk that someone who was fully protected against a decline in appraised value would let the property go to hell or do bizarre paint jobs and renovations that would repel potential buyers. Disadvantage of an index-based approach: If your property falls in value more than that of the city index, and you bought downside protection, you're out of luck.

Liu has tirelessly sought support from lawmakers, regulators, and investment bankers for his concept. He says several bankers have told him they're interested but don't want to be the first to move. Says Liu: "Nobody wants to stick their necks out." On the positive side, lawmakers and regulators are eager for new ideas to cope with the coming deluge of delinquencies and foreclosures. In August, Federal Reserve Chairman Ben Bernanke wrote to New York Sen. Charles Schumer endorsing new ideas for mortgages, including shared-appreciation loans, of which SwapRent is a new variant.

Reader Comments

Chinni Tung

October 12, 2007 3:05 PM

What a smart and encouraging concept! It should be introduced in the market earlier.

T.

October 15, 2007 2:16 PM

Ralph Liu is definitely onto something. As the whole structure of the housing/mortgage market changes we need new products and new ideas. SwapRent like other derivative products
available to institutional client can now help the homeowner with "risk". And that is what it is all about. If a homeowner can buy fire insurance then why can't they purchase 'property value' insurance....too me same thing.

jason

October 16, 2007 10:25 AM

I think this is an interesting idea and had a few questions:
1) what kind of homeowner is the product targeted at? if it's only targeted at qualified investors, the market is small, but if it's targeted at retail consumers, are they sophisticated enough to understand the underlying pricing models for the derivatives?
2) what are the tax implications? i would think that "economic" renting carries the tax benefit associated with mortgage payments, whereas renting isn't tax deductible
3) is there counterparty credit risk, and how is that managed? if a homeowner sells a call and cash settles at exit for a loss but doesn't have the cash on hand, doesn't that force the homeowner to sell the house

Ralph Liu

October 16, 2007 9:24 PM

Hi Jason,

Thanks for the excellent questions. I will skip those part of the answers that may have already been incorporated in the Q&As on the SwapRent.com web site. Please refer to the web site for those information.

1. SwapRent (SM) is specifically created as a consumer product for the mass market and is intended for a broad audience. Almost everybody who may or may not even own a property at the moment can benefit from the SwapRent (SM) embedded consumer financial products. A good example is the "anticipatory hedge" transaction for current renters as discussed in the section of the 5 economic advantages on the web site. For most end-users such as the current homeowners they would not go to the banks to do an outright SwapRent (SM) trade for the lack of sophistication reason you mentioned. They will be using the SwapRent (SM) embedded mortgage products called HELM (Home Equity Locking Mortgage) for such purposes. The idea is to create new a generation of mortgage products that will have all the economic advantages of these new property derivatives built in and delivered to the homeowners in a conservative, fool proof and transparent way in order for them to benefit from it without having any possibility for them to get into any detectable future potential troubles. Therefore the homeowners really would not need high level knowledge of derivatives or capital market instruments in order to benefit from them. Just like the case that the consumers may not need to know how the car engine works but as long as they focus on mastering safe driving techniques it should be good enough. Banks in fact have been marketing derivatives in the form of mortgages without calling it a derivative for decades. For example, a 30-year fixed rate mortgage with a prepayment option is in fact a long term fixed rate loan with an interest rate derivative built in. But as you might recall that last time you refinanced the bank did not ask you to sign an ISDA agreement and treated that as a derivatives contract. Through free market competition many banks lowered or waived the option premium on the prepayment feature. In the end homeowners benefit. Homeowners have never got into any kind of troubles with this type of derivatives that have been built into the conventional mortgages.That is exactly what HELM, the SwapRent (SM) embedded mortgage is supposed to do.

2. Proper tax treatments will usually come naturally once the new business has been properly introduced. Any existing tax codes that may hinder the growth of an innovation may be changed later on as time progress as was illustrated in the case of the recent preferable British tax code changes for treatment on commercial property index derivatives. As usual a suggested tax treatment will be helpful in that process. For example, the most natural way is to abide by the off-setting rule to the income tax treatment, i.e. if the homeowners receive the mortgage funding cost (MFC) from the investors then the income tax deductibility has to be offset by the amount received during the current year and the investors should be able to claim that same amount for their income deduction. As for the capital again tax treatment all they need to do is to adjust the original tax cost basis whenever they receive either the index profit or loss at SwapRent (SM) contract settlement date. There are more detailed discussions in our business white paper. For those interested please feel free to contact us directly.

3. You brought up an important point. It appears that you may be banker as well. Any financial innovations for consumers could be only hot air or may remain wish list items forever if the financial institution providers can not figure out a reasonable way to manage or transfer the risks, either counter-party credit risks or the market risks to make the new product ideas realistic. So a short answer to your question is that the counter-party credit risks for homeowners are handled through the SwapRent (SM) embedded mortgages on the liability side and the counter party credit risks for investors are handled by the SwapRent (SM) embedded structured notes or structured deposits on the asset side. In addition, banks are quite familiar with the common margin trading arrangement for both the investors and speculators. The homeowners would not have to sell their houses when the they have a mark-to-market loss, they will simply have a larger borrowing amount on their HELM, a special innovative feature. Again due to the space limitation, more information could be provided separately.

I hope these answers are helpful. Thanks.

DaveC

October 17, 2007 11:00 PM

I sent the links to the finance professor in my EMBA program. It is innovative and workable. I guess the devil will be in the details. But that would be true in almost everything. I am impressed by the simplicity of the concept. It's one of those "Why didn't someone think of this earlier?" It is almost always much easier to create complex solutions to complex problems. It is rare to see something that seems simple and is yet powerful.

Norm Miller

October 21, 2007 12:35 AM

SwapRent is a nice innovation and many homeowners in California and throughout the country would have been much better off had they utilized such a vehicle. Dave Geltner and I conceived of HEITs many years ago where owners would hedge or trade away local upside (or price risk) for national or regional indices, but SwapRent is better at isolating out the cost of occupancy from the investment aspects of ownership. It is an idea worth pursuing further and might even save some foreclosures if the details can be worked out quickly enough.

Norm Miller
University of San Diego

Stathis

October 23, 2007 4:44 PM

SwapRent is a superb new concept, consistent with the goal of making markets complete. Housing markets are notoriously inefficient, with price rigidities, asymmetric information, and often exhibit long-term disequilibria. Introducing the new derivative instruments would help in making the housing markets more efficient, which would help alleviate crises such as the current real estate debacle. It would certainly even out the boom & bust cycle phenomena that are observed in real estate markets worldwide.

Lee Kravitz

February 14, 2008 4:11 PM

Ralph,

It was a pleasure meeting you this past Saturday at Harvard. I have taken the time to read your proposal for SwapRent and to educate myself on how derivatives work. I am still a neophyte but think I grasp the concept of what you are trying to do. I have also read several comments in articles and on blogs that have referenced the SwapRent model.
I am convinced that SwapRent is an excellent solution for some of the properties currently affected by the mortgage “crisis”. I also believe that anything that provides an alternative to foreclosure should be promoted.
I am uncertain that the SwapRent model can be applied to distressed properties in blighted areas with little prospect of appreciation.

I have several questions and comments:

1.My first concern (from an investor’s viewpoint) is the level of risk versus the potential pay-offs. I'm sure you have studied this. My calculations seem to indicate that a property would have to appreciate @ 18% over a 5 year period for the investor to merely break even. I then looked at what an investor could earn in a "safe" investment using an annual rate of return of 5%, for the “landlord” to match that performance the property would have to appreciate @ 29% over the 5 year period.

Is this a reasonable expectation?

2. Based on that level of appreciation do you believe that there will be sufficient investors to offset the demand? Have you studied/identified what percentage of the market can perform sufficiently well to make this an attractive proposition to an investor?

3. Does the SwapRent model use average rents and average mortgage carrying costs (interest) in a given MSA? Will the landlord's payment be sufficient to keep the owner from defaulting? I would like to see an example using real world figures of how this payment would work.

4. As it stands currently there does not seem to be any benefit (deduction) for mortgage interest paid by the investor nor any exemption of taxable gain for the renter.

5. Based on example (b) in your paper, where the value of the property dropped significantly, what guarantees do you have that the investor will actually make the capital payment required? Will the bank agreeing to the HELM require some form of cross-collateralization from the investor?

6. What happens if the owner (renter) defaults after entering into a SwapRent contract? How do you mitigate the risk involved with extending further credit to sub-prime borrowers? My understanding is that the SwapRent would be secured by a second mortgage (HELM). The investor's chance of recovering anything in a default would be quite slim in this case.

7. While I believe that SwapRent is an excellent answer to the current crisis, what effect do you think artificially maintaining or inflating prices of real estate will have in the long run (over where they would end up without intervention)?

8. Do you have any projections as to the number of renters that will be able to afford their properties at the end of the SwapRent contract? In this context, is SwapRent a cure or merely postponing the inevitable?

9. Is there any concern that SwapRent will override market forces by letting people buy more house then they can afford (ie: first time home buyers and speculators) leading to a repeat of the current situation?

10. I am not convinced that "renters" will keep up their properties based on knowing their improvements will benefit the "landlord's" equity first, especially in a model where 100% of the appreciation is traded.

11. In an example where the property does appreciate and the loan amount is increased to pay off the investor, why do you believe the owner will be able to afford a payment that is equal to or greater than what they previously could not?

12. Have you identified the optimum criteria (profile of property type, borrower, MSA, etc.) for the SwapRent to perform as desired?

What criteria are you using for your model?


13. If the MSA (local tracking index) appreciates at a significant rate above the actual property, what happens if the owner cannot get enough funds out of the house to fulfill the contract? Example: an MSA with significant new construction that skews the average values upward. When the bank refinances or increases the size of the mortgage to pay the contract it will want an actual appraisal of the property.


I think your idea is both brilliant and simple, and would welcome the opportunity to chat with you about it. I believe it is viable and have clients that could benefit from it right now. Have you considered any implementation requirements (ie: mandatory credit counseling, etc.) that the public will have to complete to educate themselves and to increase the success of the program?

Regards,
Lee Kravitz, SVP
Source Funding Corp.

Ralph Liu

February 15, 2008 5:56 PM

Hi Lee,

Thanks for the spending the time to have a very thorough understanding of SwapRent (SM) and its related financial products. Your questions are excellent. It is to be expected from a seasoned mortgage and real estate professional like yourself. Here are my views.


1. The return expectations among different assets classes or various investment opportunities are just expectations. For some individual investors or speculators they may have stronger views on certain investment opportunities to get rewarded for their financial diligence and luck or punished by their stubbornness and carelessness. For institutional investors they could add on another valuable asset class to diversify their long term investment portfolios. Before the SwapRent (SM) based approach is available they had not been able to treat the residential real estates as an asset class (other than apartment complexes which are treated as really commercial properties) in the past which happens to be the world's largest asset class. Now they could enjoy the benefits of portfolio diversification to achieve higher risk-adjusted returns by adding residential real estate exposures in their portfolios by simply receiving SwapRent (SM) payments based on say, city level property price indices.

REIDeX aims to provide such a trading market for investors and hedgers/homeowners to express their individual views and would not want to in any way influence their investment decisions the same way that NYSE would not want to influence the stock investors' decisions on whether certain stocks may or may not have better returns than certain bonds. Investors views could simply be reflected by the trading levels of Generic SwapRent (SM) rates, AG SwapRent (SM) rates or DP SwapRent (SM) rates based on the local property price indices, again the same way expressed as the stock prices for the stock investors buying and selling stocks at NYSE.

In your example of a 5-year SwapRent (SM) contract, if the investor expects to have a minimum 29% returns on property in certain city, he/she could offer to receive Generic SwapRent (SM) rate at as low as -1% (assuming the same MFC rate of 5% that will give a annual 6% subsidy to the homeowners) to break even. If he/she receives Generic SwapRent (SM) rate at 2% (with annual subsidy of 3% to the homeowners), anything above 15% (or 18% in your more precise calculation) will be his/her gains. Again he/she can simply expressed what he/she expects or desires by simply specifying what level of the Generic SwapRent (SM) rates he/she wants to receive to consummate a mutually agreed trade.


2. Given the current market situations there could be many different types of investors who would be interested. Let me just focus on one type of investors as an example since the space in limited here. The most obvious ones are the same banks, hedge funds and other types of domestic and foreign investors who already hold these distressed mortgage loans, MBS and CDOs. If they simply become the "economic landlord" investors by receiving SwapRent (SM) rates from exactly the same mortgage borrowers so that these mortgage borrowers do not have to default or be foreclosed. Once the mortgage borrowers' downside market risks are hedged and the default risks are eliminated by receiving the subsidies through paying SwapRent (SM) rates and receiving MFC (Mortgage Funding Cost) from the investors the value of these existing mortgage loans, the securitized MBS and the more complex structured derivatives such as CDOs that were based on these loans will all recover in a big way.

These same investors would of course be motivated to offer much more attractive levels of annual subsidies to homeowners through offering to receive much lower Generic SwapRent (SM) rates since they could profit from the revaluation of the mortgage loans or related assets and complex credit default derivatives they already own. We could call this type of activities Assets Restructuring and Revaluation (ARR) and they could be the best immediate investors to offer immediate solutions to homeowners to hang on to their homes.

After the market scare has calmed down, their mortgage loans and related derivatives will have recovered and will become salable at a much better price level. They could securitize them again if they want to. Business will be operating as usual again. Later on they could make the decisions at ease on whether to continue to hold on to these long term recovery (5 or 10 years) long residential real estate property exposures expressed in MSA based index level SwapRent (SM) contracts all across America. Since the dark clouds over the real estate markets are already over many traditional long term investors such as pension funds and insurance companies may step in and bid up the prices of these SwapRent (SM) contracts again. The speculators and hedge funds will also become itchy and voila, the crisis will be all over.


3. The SwapRent (SM) rates reflect more than the real average physical rental rates in a given neighborhood or city. Among many other things it would include the expectations of the potential holding period returns that includes the expected price changes in the contract periods. The levels of the Mortgage Funding Cost or MFC are simply the interest rate swap rates given the contract maturity periods so that we could avoid considering individual credit spreads due to the particular credit quality of the homeowners. The sufficiency of the amount of subsidies will be reflected by the trading levels of the SwapRent (SM) rates. If a certain maturity or contract notional amount (percentage of the house value for economic renting) does not generate enough subsidies they can simply choose longer maturity contracts and/or larger contract notional amount (higher economic renting percentage). If it is still not enough, they could simply opt to use the AG SwapRent (SM) contracts instead.


4. As I mentioned in the blog comments before that the tax men usually would not be able to anticipate what the financial innovators are going to create. Therefore the normal and reasonable tax treatments will naturally evolve once the business has been introduced into real practice. They would not be able to issue a particular set of treatments before the practice already exists. Common sense should prevail on how they should handle them at that time.


5. Yes absolutely. Collaterals such as what are normally required in a margin trading contract when banks deal with their private banking clients will be more than sufficient. The practices are very common and banks and brokerage houses are very familiar with them. In addition, I described in details in the business product white paper which is downloadable from http://www.swaprent.com/aboutus.html that the banks and brokerage houses could use the property index embedded structured notes (PILN) or simply the structured deposits (REILD) to manage the counter-party credit risks of the average mass retail customers. Alternatively, if the investors use AG SwapRent (SM) there would be no need to worry about their counter-party credit risks.


6. Not really. The future liability will be collateralized entirely by the future home equity gains. HELM is a wrap-around package of the existing 1st mortgage and a contingent 2nd mortgage from the banks' perspectives. From the borrowers' views they are simply a new type of mortgages they can either start anew with the bank for a new purchase of a property or the could simply convert from an existing mortgage into it without much further transaction cost.

The new feature is that the borrowing amount will be automatically changed based on where the property price index is from the original level at the start of the conversion or the new underwriting. Therefore the only scenario that the banks will worry about additional credit risks are when the property values have increased from the original value, i.e. when the economy is strong and the borrowers' jobs are secure. In one short sentence they will only have to pay up when the time is good. It is a far cry from the current distressed situation.

From banks' operational perspective, they could simply offer a 50% (or 75%, 80% etc.) initial house value limit of the percentage for economic renting in order to manage the counter-party credit risks in a very conservative way. There are many operational leeways on how this could be handled. In that case the homeowner only has to give away $100,000, i.e. 50% of the upside appreciation gains through the increase of the unpaid balance of his borrowing amount of his/her HELM when his/her house value as represented by the index has actually increased $200,000 (from $800,000 to $1,000,000 as in the example of the power point file).


7. Establishing a simple parallel derivatives market such as the SwapRent (SM) market through REIDeX along side the physical real estate spot market will only make the market mechanism operate smoother with much less possibility for the boom and bust since it offers alternative liquidity and hedging opportunities. The derivatives market itself will not add or subtract any fundamental economic forces usually exerted by the monetary or fiscal policies. It will act as a "parallel market" and offers economic value only in that sense. The ups and downs of asset values will still be determined by monetary policies and other economic fundamentals. These net effects have been proven by long established derivatives markets on any other assets such as stocks, interest rates, currencies and other commodities in the past few decades.


8. Through the SwapRent (SM) contracts or the property derivatives embedded new mortgage products homeowners can either hedge the current values of their properties or receive current subsidies for giving up a future potential rise in the value of their properties which may or may not even be realized. Depending on how they execute the strategies the outcomes will be very different. There are hundreds of thousands of scenarios and many of these strategies could simply be borrowed from good and conservative experiences executed in derivatives markets on other assets in the past.

In the current context of rescuing the subprime borrowers, SwapRent (SM) could avoid altogether or at least postpone the defaults and foreclosures much longer than what could be achieved by simply manipulating the interest rates alone. It offers a totally different dimension. The differences are 5, 10 15, or 20 years in an equitable and willing way for SwapRent (SM) contracts vs. a few months or a few years for arbitrarily freezing rates and foreclosures where one party (either the bank or the borrower) has to suffer from modifying a previously agreed mortgage contract by changing the interest rates. Even if the banks say they will swallow the loss or the negative equities of the properties, the banks' stock investors should ask why and question these management teams on whether they have performed their fiduciary responsibility before giving away the money so easily while other more equitable settlement loan mod methods such as through SwapRent (SM) contracts are available.

Economy works in cycles. When postponing an event in an equitable and willing way through transferring the associated risks and rewards through a legitimate derivatives market for a chosen period of time the undesirable events could be avoided forever. So those events will not be inevitable anymore. Derivatives markets act as temporary shelters. Those are exactly the hedging and financing economic benefits that a derivatives market could easily provide to the underlying market participants.


9. The current situation is a problem because there is currently no established SwapRent (SM) market. If the SwapRent (SM) market already exists they would not have been a problem to begin with. That is the exactly the same housing affordability economic value that a SwapRent (SM) market can offer. More related info is available on that particular point at the www.SwapRent.com web site home page.


10. Oh you may be confused on the valuation methodologies. The moral hazard and the home improvement issues are exactly what have plagued the shared equity or shared appreciation mortgages or equity fiance markets in the past as practised primarily in the UK. Those are exactly what a SwapRent (SM) market and its embedded mortgage markets are mean to prevent. The preferred implementation is to use a set of neighborhood property price indices. Thus these issues could be easily avoided. More info on the how to create an ideal set of such property price indices is available in the downloadable business product white paper at the www.SwapRent.com web site.


11. Indeed they could be qualified for such future income capability first by the financial institutions in a very conservative way if the providers want to. But that may not be necessary. The banks could alternatively simply let the homeowners extend again the terms through establishing a new SwapRent (SM) contract, maybe for longer terms across the intended occupying period or even the expected life time. In addition, they could also easily use further leverage of contingency through AG SwapRent (SM). Comparing with a long term reverse mortgage contract to extract cash out of their properties which are currently already available to the homeowners in this extreme scenario the heirs of the homeowners may still get to own the property in whole at the end of a SwapRent (SM) contract while they will lose the property for sure as in a reverse mortgage contract. A more detailed numerical example is again available on the home page of the www.SwapRent.com web site.


12. Theoretically the economic values of a SwapRent (SM) market could be easily extended across the board of all kinds of properties, including commercial properties such as offices, industrial complexes, retail shops apartment blocks, hotels and so forth. Like any other economic theories or financial tools, the end results will be different in the hands of different management and/or different operational teams. It will really be a management or an operational issue.

We operate on a consultancy basis. The exact operational parameters will be up to the various management teams at different geographical markets under a different market, cultural and regulatory environment.


13. What you described is a double edged sword for good purpose. People who trash the properties that they own, no matter it is their houses, their cars or even the relationships of their marriages, with families or with friends. When the properties or relationships deteriorate they really have nobody else but themselves to blame. If more responsible people around them on average do much better than they do, then they will need to sit down and rethink about the strategies of their lives sooner or later or they should suffer from the consequences. It is not anybody else's job to solve that kind of problems for them. :-)

In our context, it will be exactly the same economic factor enhanced so that it will motivate people more to care and cherish the properties that they already own and the neighborhood that they already live in. Public housing will therefore have improved neighborhood quality and enjoy a smart growth. Homeowners will become more responsible citizens and start going to Home Depot or Lowe's more often and consume more to improve their homes. Our economy will only get a lot better!


Ralph

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BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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