Saturday, December 29, 2012

#16 Karl Denninger: One Dollar Of Capital - A Definition And Challenge

This post discusses Karl Denninger's article, One Dollar Of Capital - A Definition And Challenge posted 28 July 2012 in Bank Reform. I cannot really offer anything from this article concerning the present monetary system as the general message of this blog is more in accord with “come out of her, my people” than it is with rehabilitating or sustaining the present system or the order it supports and represents. My comments will reflect instead from Denninger's ideas, ways in which they would function in (the or an) VEN based on the observations of E. C. Riegel.

Denninger makes some interesting points, interesting from the standpoint of those attempting to define an alternative to the present system that would run in parallel and outlast and survive the old debt based systems. In this discussion, we are going to focus on finance, which is plainly stated, the ability for someone to buy something they can't afford. Much of the world's business has been maintained in this way, and as long as certain principles are adhered to as universal references, finance can continue. But everyone is aware that most of what besets the present system, and which shall ultimately break it, and its associated brutal collectivist order, is related to abuses of finance.

Denninger says, “One Dollar of Capital is simply the principle that nobody be permitted to "create credit out of thin air", thus artificially expanding the spendable supply of "money" in the system. This, and only this, is the reason for all of the bubbles and financial collapses throughout history.”

This is entirely in accord with E. C. Riegel's ideas. After citing many well known financial bubbles, Denninger continues,

This sleight-of-hand is in fact exactly identical in mathematical and economic impact to counterfeiting of the nation's currency, a crime which we all should recognize, condemn, and when it occurs the punishment should include both imprisonment and forfeiture of every dollar of ill-gotten gain.

Yes, Karl, we too are angry, as are now growing numbers of tens of millions the world over, but after all, weren't we warned long enough and in so many ways, never to deal with dishonest money lenders? Weren't we responsible for reading the fine print on all those papers we wilfully signed to get this or that, just to maintain our lives, including our lavish holiday celebration of the birth of Nimrod every year? Aren't we also in part to blame for uncritically “going with the flow”, of just “getting along” as everyone else has, sheep being led to the slaughter, for the profit and the benefit of the so called “chosen” few? The message was always the same too, “come out of her, my people.” So we have been warned. When someone offers you something you know you can't afford, you know there must be a catch.

Putting a stop to unbridled credit creation also removes the threat of "inflation" because it makes inflation by sleight-of-hand flatly impossible. It returns the ability to cause inflation to the one place where it should rest -- the entity that is supposed to be in control of the money supply, the federal government (specifically, Congress.) 

And of course, here is where we differ. But we aren't concerning ourselves with Congress, because we recognize from E. C. Riegel's clear rational observations that the framers of the US Constitution were seriously in error in believing they could grant to Congress a power over the creation of money that was akin to giving them the lawful authority to determine the orbits of the planets. As has been said many times now, for those who have been paying attention, the government should get out of the banking business, and the economy in general, and the banks and economic factors should leave the governing factor to those who can or would be engaged in that dwindling occupation.

But Denninger and we differ only slightly as regards inflation, he and Riegel are in fundamental agreement. Denninger comments further,

The bankers and their cronies have tried to hide [inflation's] impact on the common man through offshoring of labour so as to hold down "prices" in the CPI, but that's a lie too as a man who loses his high-paying job to some slave in China has his spendable income destroyed at the same time as he gets "lower prices" at WalMart. 

Simply put, for every dollar of alleged GDP there must be one of dollar of credit or currency with which to buy the goods and services produced.

Riegel would certainly see it this way too.

If you increase the denominator, that is, the number of units of either credit or currency in the system, then each unit must inevitably be worth less than it was before. Only when those units are exactly in balance with economic output is there zero inflation and protection of the currency's purchasing power. That is the definition of Sound Money.

We're going to elaborate somewhat here, the balance Denninger expects to achieve must remain within what Riegel called “price relativity” as regards all other natural factors in a transaction, except for the kinds of interventions Denninger and we agree would be disallowed in a rational and ethical system. Prices would wobble around a predictable average, especially where supply and demand are kept at near constant rates with respect to each other; the price of a gallon of whole milk in a particular area of a particular state in the US. Prices for the same item might differ significantly in other places, permitting those who normally would wish to do so, if it was profitable to them, to supply milk to a particular area at lower than prevailing prices.

This is normal economics and we agree that generally the numbers of units to measure value (money) should agree with the units of output value produced in an economy, however we must come to a much greater definition of what that word “output” consists before we have anything meaningful to discuss. How much business is transacted in that which was not produced in a given time period for which such measurements would be made, but is merely being traded for value in something else, perhaps even a better version of the same thing? Used houses, cars, boats, cabins, pianos, come to mind immediately. There are whole layers of economic activity that do not require anything new of value to be produced. Reducing the amount of money in circulation to only that which is produced, sounds good, and reasonable, but is it? We actually claim that the ultimate measure is as Karl Marx thought but couldn't understand properly, the value of human labour. Everything else should rightfully be judged in price accordingly. The only trouble is that everyone has different ideas about how much their labour is worth doing certain skilled or semi-skilled occupations. This is why money based on hours worked has got its own problems. As Riegel thought, one has to let the money value the labour, not the other way around. (The or an) VEN would do this.

Denninger's article here contains many stand out principles that can be addressed as regards the functioning of (the or an) VEN:

Banks are limited to depository institutions. They are forbidden to speculate or trade in asset markets.   

In an VEN, the “banks” are called “exchanges” and are depository institutions that do not have as part of their charter the loaning of money. You wont be able to get loans through an VEN in the usual way. These functions would be taken over by other private businesses that agree to the VEN Rules of Finance, which specifically stipulate that no extra money can ever be lawfully created; the elimination of usury. The VEN makes its money from transaction fees only, we're talking a rather low end job here in comparison to today's remunerations for bankers, except that each Independent Exchange (IE) would have a real board made up of real human beings, that would have to pass (accept) any transaction coming through their exchange as part of a credit contract. The job of each IE is to settle transactions with other IE's. Each IE having a customer at the end of each transaction. These customers / traders can be either A's (individuals) or B's (groups of individuals). An A member who lives outside the bounds of an IE is a B member to that IE.

Investment banks can trade, be involved in the capital markets or whatever else they wish. However, they are forbidden deposits, government-backed insurance of any form or any sort of public assistance.   

Well, of course Denninger is talking about the present system here. A Value Unit system automatically separates these functions, strengthens the exchange centre and gives it the authority to accept or reject contractual claims made between customers as claims of settlement in transactions involving finance credit; credit contracts.

All institutions must mark-to-market every night.   

This is a laudable goal, but as applied to the present monetary system, it will never happen, because that removes from the bankers their fictional right to set values and manipulate the markets. We prefer to say that in a Value Unit based system, “marking to market” need not apply to very many items at all if it even can be a widely determined and meaningful measurement, which it may not be, and that in general the amount of money created will never be in excess of what is required to transact honest business.

No loan may be made beyond either the marked-to-market value of the collateral pledged or the firm's own capital. This forces all lending to be self-liquidating -- either through repayment over time, or through seizure and sale of the collateral posted or through the posted capital by the lending institution.

We're nodding in general agreement here; this is generally how a Value Unit based  financial would operate. One of Denninger's readers had this to say regarding a real estate loan,

Suppose I put 25% down and the bank loans me $100K on a house.

He's suggesting that (.75)x = $100K, x = $100K / .75, x = $133,333.33

The total value of the house is $133,333.33 to the buyer and he put up $33,333.33 as a down payment. Perhaps if he had had more cash at the time of purchase, he could have gotten the same house for less money. We'll definitely cover that aspect of such transactions in a future paper on markets.

Does the bank have to have that $100K or can they create it?

All such transactions concerning real estate, as they have existed down through time, are essentially the title to the property as collateral for the loan of money to possess it; forfeiture of the terms of the loan leading naturally to forfeiture of the property. Let's look at the transaction from the financier's viewpoint and then we'll arrive at the answer Denninger's reader asked.

In any real estate transaction there is a seller and a buyer. If the buyer has cash for the property, there is no need of a middle man, a financier, and probably the price the buyer pays will be significantly lower than had he to finance it. But in most real estate sales there is need of a middleman, a financier, who can settle the claims in order to get the title (deed or whatever other specifies documentary ownership), the lender must pay off those who are selling the property, so the answer is yes, the financial institution would have to have the money. They could not create it out of thin air.

So the financier (operating under contract to both buyer and seller) buys the property from the seller. The property belongs to the financier who then arranges to sell it at a higher price to the buyer for terms. In the process the entire sum of money is loaned out and recaptured -self liquidating- and the residue between what the financier paid for the property and what he got in return is retained by the financier. Is there any inflation created by doing this? If that question asks, does it have any appreciable affect on say groceries or food prices, since there is supposedly more money in circulation, the answer is no, there isn't any; any extra money is attributed as value the buyer had to incur as part of his agreement to pay back the loan over time, rather than having the cash to complete the transaction at the time of sale.

So before the buyer and seller met in the financier's offices, the financier had the money to purchase the seller out of his property and retain the deed. (We'll discuss all the valid means for financiers to have acquired their Value Units in a future paper. Take note that in most instances the financier in a Value Unit system would have to be dealing in both Value Units and dollars or some other currencies. No IE would ever deal in anything but Value Units.) In order to get the deed, the financier would have had to settle all previous claims against the property; loans, taxes, etc. That would be the base price. If the buyer had had that much cash at the time of purchase, he could have settled the matter and NOT needed to resort to credit.

In passing, there are two reasons why down payments must be large enough in regard to the properties being financed; it's called “earnest money” that the financier assumes the buyer took some pains to secure and pledge as part of the deal and also as a hedge against default of the loan on the part of the buyer.

So the financier has bought the property from the seller at his agreed price which I'm going to assume is $100K. Observe the obvious, the financier had to have or raise $100K to buy the property. The property backed the money the financier paid for it. It's now tied up in the property. Now the buyer is sold the same property for a higher price, more value added in that he could not afford to buy it with cash at the time he did and managed to come up with $33,333.33 to settle the deal. So let's be honest folks, the buyer bought today a property worth $100K for $33.333K and a string of payments to cover the rest. That's if he did it in Value Units. It would be much more if he financed it in anything else, because no IE would ever pass a credit contract that even sniffed of compounding of interest. I'll admonish all that real estate deals were usually considered of shorter duration in ancient times than they are now, certainly for undeveloped land or land requiring remedial labour to bring it into full productivity.

So the loan would probably be much shorter but once the loan is paid off that money would disappear into what? Into what it bought, the owner's real estate. The financier would win his time value on extending his credit to the buyer, just as in usury, except that the transaction would be paid entirely as money that was created, out of the purchased price of the real estate, rather than from money that was not created as in an interest bearing loans.

What happens when a forfeiture occurs? The financier loses whatever portion of the loan that is uncollected and has to foreclose on the occupants and put the property back on the market for whatever he can get for it. If the financier is caught with more property to sell than he has money with which to work, he loses, goes out of business. One reason we want finance to be kept out of the centre of transacting business is that all finance is inherently risky, which will be covered in a future paper on markets.

If they can create it, it does inflate the money supply but it is self-liquidating, just over a much longer period of years. Is there an advantage of being an early borrower in such a system, or is such advantage, if any, only at the very beginning, in that we would soon reach steady-state?

Markets that rely on finance have such questions attached to them and the longer the period of payoff -destruction of previously created money- the more they become pertinent. But in a Value Unit based system, many such practices are disallowed as they run against acceptable risks and tend to contaminate or make lopsided any rational market.

On real estate, there may need to be two more conditions, on top of say a minimum of 20% down. One, NO programs of ANY TYPE to help people get the down payment. Two, unless there is fraud or destruction of the property, all loans are non-recourse. The bank takes the collateral and its over.

Further comment:

All credit that is self-liquidating is inherently a time-shift of demand. That's why most economists ignore it in their computations.

But if that's the use of credit (self-liquidating, irrespective of time) then credit should grow at about the rate of GDP. It hasn't -- it has grown much faster. This is proof that the intent is otherwise than what is stated.

Indeed! Which is precisely why we wont accept governments as members of the VEN from their inception. E. C. Riegel had ideas concerning how governments would be allowed to participate in (the or an) VEN, always as B members, so they would never be allowed to issue money, and in agreement with Bill Still and others, would never be allowed to go into debt. Under present circumstances, we are aware that much including the measurements of GDP, unemployment and much else, are unreliable.

Self-liquidating credit temporarily increases the money supply but when it is matched against an asset that is impounded as collateral while the money supply increases the total amount of wealth in the system does not; it is purely a swap of liquidity vs. wealth. 

I want to point out a common fallacy here. By it is purely a swap of liquidity vs. wealth the reader is attempting to come to grips with the concepts of money and assets. Liquidity of course refers to cash and that which can easily be converted into cash. Assets can be passive or active, can depreciate over time, etc. Wealth is that which produces something of value based ultimately on income over expenses; not all assets are wealth in the commonly held sense.

If someone has a lot of something, assets, even the corner on it (a near monopoly so that they are almost the only supplier), if that commodity doesn't sell at the seller's conceived prices, though he might have nearly all of it on earth, sooner or later the price he sells it for will tend to fall. Diamonds fall into this category. So in fact might oil. Both are price protected commodities. Whenever this happens, it's a sure sign that probably the natural price would be lower. Labour unions also try and protect a certain price for certain kinds of labour. The results are much the same.

If you forbid lending without 100% reserves even collateralized then you are effectively imposing a 200% reserve where collateral is taken!

This reader is referring to the well known maxim concerning cash required to maintain any retail business, known liquidity as retained replacement value; the lender would have to have at least twice the amount loaned on hand.

This would be ridiculously deflationary rather than neutral and would immediately cause all lending to become uncollateralized since the price of the loan would go up to reflect uncollerateralized status even in the presence of collateral (that is, nobody would post it as there would be no differential in price.)

We agree with this for the most part, but would suggest that everything forward from here is deflationary, since there is already too much inflation in the system, certainly in real estate, and in the government budgets for things that the government should not be doing, all paid by acquiring more debt. Terrible! Until and when this all crashes, and real estate falls to its real natural value relative to other common commodities, and governments shrink dramatically as they will indeed be forced into doing, no true and honest system can be constructed. Again, those out there asking for a fix or aching for a band-aid to the present system are warned; there is no fixing what cannot be fixed, there is no turning back to a “better time” which wasn't, there is only going forward through the Inevitable collapse and beginning again and anew by NOT doing again what has been done before. Thou shalt NOT lend at usury. “Come out of her, my people.” Denninger continues,

For banks if they wish to lend unsecured (e.g. for a credit card) they must have either sold stock to investors in the amount of the loan (and have the cash proceeds set aside), have sold bonds to investors (and have the cash proceeds set aside) or have retained earnings that they set aside.

Good heavens! We care not what path others may choose, but as for us, give us liberty or give us death. We will not have need of such unsecured loans and they will not pass the inspection of any local IE within a Value Unit system. Thus shall we be free of the unsecured credit menace, and its ability to entangle one in endless debt, once and for all. Denninger continues,

A secured loan (e.g. a letter of credit, a home mortgage for less than the home is worth, a car loan for less than the depreciated value of the vehicle, etc) may be made without capital being posted as the security is the capital.

This kind of loan and its basis are likely not going to pass muster for most financiers in a Value Unit system. What we anticipate happening in the VEN system is that as the exchanges come on line and begin trading with one another that various capitalized businesses will appear to offer legitimate financing within the Value Unit economic sphere, probably specializing in various lines of credit business. This will all be explained in a future paper.

The kinds of agreements under which these loans are made would have to pass examination of the boards of the local Independent Exchanges (IE's) through which they would pass; be settled as in a business transaction. There would be strict rules applying to board members and approved finance agreements to eliminate conflicts of interest. Failure of VEN officers or financial businesses to respect professional distance would result in officers and businesses being denied service by the admittedly private IE's. When one joins an IE, one is making a private agreement that is subject to the enforcement of the rules ONLY by the members of the VEN, not by anyone else. If you break the rules and get caught in the Value Unit system, you're out of the trading community, probably not forever, but for a good long time. We expect to have an honest monetary system, one that is completely open to everyone who needs to know, which in most cases is going to be surprisingly few people.

Would that in essence allow banks to create some money, and thus inflate the money supply, but in a very limited way? I am trying to grasp every nuance of this idea.

I happen to think that perhaps the reader has stumbled upon a realization concerning expanding money in a wasteful manner, by allowing abuses such as home equity loans, or even equity loans on classic cars or works of art. This is sort of having one's cake and being eaten by it too. One always pays more for what one cannot afford at the time of purchase and pays more later than sooner so as to shrink for the duration of the loan the available monthly budget.

Even assuming that such loans would work in a Value Unit based system, their benefit seems limited, except to those who lend money, the financiers. Under a Value Unit system, they must have it to lend to begin with, so no, they do not get to create money out of nothing, But they also cannot charge interest, so the only way a financier would be able to operate in a Value Unit based system is as a middleman, buying at wholesale and arranging terms at retail. All such financing never creates more money than is absolutely required to satisfy the transaction and certainly never asks more than was created.

However, since any asset may depreciate in value (e.g. a car) the assets must be continually marked to the market and if the liquidation value falls below the outstanding balance of the loan the bank must post actual capital for the difference on a nightly basis.

Denninger is describing a class of loans that would probably not pass muster through any IE but this just shows you what one would need to do to make loans of this kind work, and even so, what if the car is totaled, the furniture burned in a fire, the house destroyed by flood or earthquake? Those who live on credit and those issuing it both take their risks as do those who manage to own their property free and clear. Denninger has an idea, a zero barrier,

We maintain a statutory "zero barrier" on excess actual capital in all institutions that have the privilege of lending against assets, at a level high enough to prevent a negative equity event from occurring.

This actually addresses the question regarding how much reserve a lender must have on hand, how much extra cash or liquidity they must have, to more than cover their outstanding loan business.

The zero barrier should be set somewhere around 6%, the former reserve ratio before Greenspan and Bernanke began tampering with it, and any violation of that excess capital requirement must lead to immediate seizure and liquidation of the firm. Banks and Investment Banks are free to dance as close to this line as they wish, but if they cross it the consequence is immediate business failure.

Of course, Denninger is referring to the present monetary system. Under a Value Unit system, each of the lenders would be required to meet certain requirements to float “credit contracts” through (the or an) VEN. It might be that this “zero barrier” as proposed becomes one of these rules as a kind of “third rail” that automatically disqualifies the lender that breaches it from further participation in the VEN market. We'll have to look at the implications for parties to credit contracts under an VEN to determine the ramifications of a lender's sudden insolvency; we've already considered somewhat the effect of a default on a loan involving real estate. The implications for a wider variety of financing credit contracts would be similar.

All institutions that lend against assets must publicly disclose all transactions, marks and capital every night.

You can't always get this information, so even at best posted “marks to market” would be an approximations. If Denninger is limiting this to a firm's positions in a stock or bond market then we really don't care about such things as they wont exist in anything like the same form in an VEN since many business models and concepts are automatically disallowed under a Value Unit system. We will not allow “limited liability” for example, neither will we allow interest (money that is never created demanded in repayment) compounding of interest (the same as the former on steroids), nor a “public corporation” with an unlimited lifespan capable of being owned by absentee owners, no thanks. We intend to move forward with full accountability and responsible business ethics, not just more of the same.

The price of being able to lend against assets, temporarily increasing the supply of credit in the system, is that you must prove each and every day that you are not counterfeiting. Any institution can choose to avoid this disclosure requirement by lending only against its own capital and not claiming asset values [to] "secure" its lending. Since most financial institutions will not want to disclose this information, other than depository firms will likely choose to be investment banks and lend or finance only with the capital they actually raise.

This is a far reaching statement as applied to the present system, and of course financial institutions will do what they please rather than adhere to any arbitrary rules that confine their business. That's the way things are and have been and will be. But to us in the alternative movements that do not believe in either the efficacy or ethics of the present system, see it's inevitable collapse and demise, etc. we want to be thinking about how these ideas might apply to (the or an) VEN.

We have established that the financial service businesses will be separate from each local IE, that their business and the credit contracts they become a party to, must meet requirements set by the IE (rules will be promulgated to apply to all VEN relationships and will be agreed to as part of each member's private association with the VEN). We frankly anticipate credit contracts serving a far more limited role than they do today. We are far more interested in establishing a means to allow small business to get established and prosper, especially local farmers, dairymen, ranchers and local food processors. As far as we're concerned, the best way to prove who the “useless eaters” are, is take part in and take over the food producing business, returning it everywhere to local people who care about what they produce and about serving local people. We will be focusing on what Riegel described as self-financing labour in a future paper which once these ideas are understood should radically revolutionize the way we all do business.

Note that a move to One Dollar of Capital immediately resolves all derivative concerns, since every underwater position must be netted every night against actual capital. If you cannot post actual capital on an underwater position you must liquidate the position. This instantly de-fangs the derivative monster.

How much better and healthier is everyone going to be when all this “making money on money” without producing or exchanging anything of real value just goes away? None of this is of any concern to (the or an) VEN. There wont be any stocks, bonds, or derivatives although there will be certain kinds of “pay it forward” labour contracts. Denninger sums up his description of his One Dollar of Capital idea with a reference to deposit insurance. As previously noted, there wont be any need for deposit insurance for any account at any IE because none of that money belongs or shall ever belong to an IE. No IE makes loans so they don't derive their income from supposedly making loans on the reserves of their depositors. Riegel dispensed with the entire fractional reserve banking model and so shall we.

Since no institution can "create credit" there is never systemic risk. Deposit insurance would be unnecessary except that we have a 30 year history of the government refusing to do its job and even participating in book-cooking schemes; during the crisis IndyMac allegedly back-dated deposits with the OTS, its government regulator, aware of the practice and in fact the same individual allegedly responsible this time did the same thing during the S&L crisis. Because we cannot trust the government nor can we seem to prosecute government agencies and individuals successfully when their malfeasance results in the loss of customer funds, FDIC insurance must be maintained.

A reader comments ...

WHO is 'We' and; how will these standards be imposed IF the Government and the Bureaucrats cannot be trusted, controlled, restrained or punished? The problem IS NOT one of Regulatory Statutes: it IS a problem of Regulatory Capture and Corruption.

Citi-Group and Travellers were merged with the 'approval of Regulators' despite clear -absolutely 100% clear- legal prohibition to that merger.

-The Legal Prohibition DID NOT Matter!

-Laws and Rules DO NOT matter and WILL NOT be adhered to.

-There are no Structures in place to allow the Citizenry to directly challenge the activity of Government Bureaucrats.

-The Courts DO NOT Function.

-Separation Of Powers My Ass: the Courts AUTOMATICALLY side with the Government which gives them 'Legitimacy' in the first place.

-It's NOT an Unconstitutional Mandate: It's a TAX for NOT COMPLYING with an Unconstitutional Mandate!

-The Dept. of Justice does not function.

-Voter Fraud? Gun Running? Money Laundering ( at the Banks! )?

-Congress DOES NOT function. Dept. Ceiling? Pass the Bill to find out what is in it?

Promoting ANY Regulatory Regime WITHOUT True and Actionable provisions for Punishing Regulatory Inactivity and/or Collusion is -forgive Me- IDIOCY or INSANITY; -and will achieve NOTHING.



NOTHING whatsoever will be solved without merciless violent punishment of so much as attempts at Bureaucratic Exception and Regulatory Inactivity.

We merely point out that this represents a typical kind of rant these days.  Grist for our mill ultimately, as trade must and will happen and an honest money system that is rugged and durable shall long survive, regardless of what other asinine things people in other monetary systems may do [we lately may have at least one more to add to this list]  Another reader wrote:

I got an e mail from my congressperson. She wanted me to take a "tax cut survey"

First question: End all tax breaks for those making more than $250,000 a year so we can invest in infrastructure and education.

Of course she is a democrat and heavily union supported. If I were to actually waste my time filling out her little survey, what good would it do? These *******s can't even pass a budget, and we operate on continuing resolutions. If congress can't be responsible enough to pass a budget, how could they be expected to be responsible and pass one dollar of capital?

Rhetorically, they wont.  Bothering with politics to settle anything is a waste of time as Riegel pointed out.  Anything new must be done privately and on a volunteer basis.

With One Dollar of Capital Lehman could have gone broke and it would not have mattered, beyond Lehman.

We in the VEN world will want this too; if a lending institution fails it only affects them and their parties to credit contracts, not the entire monetary system.

Companies go bankrupt all the time; systemic risk only arises when you permit firms to commit acts that on any rational analysis amount to fraudulent emission of "money" such that they can imperil everyone else if their deception is forcibly recognized by the market.

We quite agree and would of course expect this in a Value Unit system. At least we understand that even in a business bankruptcy, the people involved are still people and will need to have a real (though limited) safety net to fall back on, which is what Riegel after all advocated and what (the or an) VEN will provide.

David Burton


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