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Concise Explanation with Blame Assigned

Look, it’s perfectly possible to explain the sittutation clearly and concisely:

* starting in 1977, we’ve increasingly forced banks to make more risky mortgages by government fiat[1]
* in order to reduce the risk, mortgage backed securities were invented
* in order to pass risk from more risk-averse firms to less risk averse firms, credit default swaps were invented.
* the quasi-governmental agencies that bought mortgages and pushed these mortgage backed securities, full of political cronies[2] and spending big on lobbying[3] , were in obvious danger; there were extensive calls for greater regulation and better oversight, starting in at least 2001[4]
* the danger was pooh-poohed, largely by people who were receiving big contributions from the lobbyists.[5]
* when the quasi-governmental agencies that has financed and securities the mortgages collapsed, many people who had trusted that the government sponsorship of these agencies made then extremely safe, found they had lost a lot of money.
* when they then decided to get out of the risky securities, even at a loss, mark to market caused everyone else to mark their securities down too — which caused them to lose value, which those people to sell as well, in a vicious cycle
* which caused the credit rating agencies to down rate a lot of firms, which then triggered the credit-default swaps
* and firms which had sold credit default swaps found themselves with demands that they pay cash for this suddenly illiquid security
* which caused the illiquidity crisis

The illiquidity crisis and the general panic in the markets for mortgage backed securities and associated credit default swaps made it very difficult to evaluate who might and who might not fail:

* with no reassurance that they could be paid back, people stopped issuing loans in the commercial credit and interbank market.
* which, if it continues, could at any pretty much any time cause payrolls to fail and retail business to be severely hurt (like “no bread on the shelves” hurt.)

* which would be a very very bad thing.

  1. Community Reinvestment Act, signed by Jimmy Carter in 1977 []
  2. Franklin Raines, Jim Johnson, Jamie Gorelick []
  3. Senate: Top recipients, in order of total career amounts: Dodd of CT, Obama of Illinois, Kerry of Massachusetts, Clinton of New York. Top recipients in dollars per year in the Senate: Obama of Illinois, Clinton of New York. House: by total: Frank of Massachusetts,… []
  4. President Bush warned of the danger 18 times since 2001. Sen. McCain authored a bill in 2005/2006 to force better accounting standards and independent oversight. []
  5. These bills were defeated, thanks in part to the efforts of Dodd of Connecticut, Obama of Illinois, Kerry and Frank of Massachusetts, and Clinton of New York. []

{ 14 } Comments

  1. shellbell858 | 2008-Sep-30 at 15:20 (@680) | Permalink

    The Act was passed in 1977, are you telling me the subprime lending wave that hit from 2004-2007 was because of a 1977 law? That doesn’t mathmatically nor logically make since.

    The banks who account most of the subprime unsecured risky loans are mortgage service companies and affliets who are not subject to the California Reinvestment Act and therefore are not regulated by the government. They targeted low income minorities to take advantage of this group of homebuyers. This is NOT the same as backing loans to QUALIFIED low income homebuyers. McCain sought to DE-regulate the depository and lending institutions subject to the CRA because he and republicans alike felt government regulation is bad. I still can’t say for certain who is to blame but I assure you, you are completely wrong about the Democratic CRA being responsible, no matter what Fox News says.

  2. NTW | 2008-Sep-30 at 16:45 (@739) | Permalink

    Shellbell and Charlie:

    Shellbell, I think it was really the 1995 revisions to the CRA which provided the spark. But only the spark. Tinder and gas required too, to get anything like what we’ve now got. More below.

    Also, I think the 1995 CRA revision was passed after the 1994 takeover of congress by the Republicans. So this was, I think, a joint product of a Republican congress and a Democratic administration. If so, plenty of bipartisan responsibility.

    1995 to 2008 may seem too long to you between cause and effect, but the macroeconomic chickens of changes in opportunities, technologies and so on typically take awhile to materialize. Bob Fogel, the Nobel laureate in economic history, once said that if you want to see the really big economic forces at work, you have to look across decades, not years.

    I think it is right to view the 1995 CRA revision iin actual history aas “letting the subprime genie out of the bottle.” But two things are important.

    First, the technology we call securitization existed long before 1995. I am unclear (myself) whether private companies could legally have securitized subprime mortgages prior to 1995. It is clear that the 1995 revision allowed “CRA-related mortgages” to be securitized for the first time starting in 1995.

    The question here is, what is the appropriate counterfactual to compare against actual history? That is, suppose that a privately contrived subprime mortgage could have legally existed in the absence of the 1995 CRA revision. Then, would banks or mortgage lenders (e.g. Countrywide), with the financial wizardry of securitization experts (Bear Stearns), have figured it out anyway (in the absence of a regulatory event that hastened this particular financial innovation)?

    Even if not, there is another important point. Lots of private mortgage-selling companies seem to have originated subprime mortgages, financed by Wall Street securitization, on their own. I don’t think every subprime mortgage (or normal mortgage) has to be backed by Fannie Mae or Freddie Mac. Indeed, I think mortgages over a certain dollar figure were never allowed to be backed by the GSEs. But certainly such mortgages existed. Perhaps such subprime mortgages exist too.

    If so, there is some volume of the bad paper that the GSEs were not DIRECTLY responsible for. I do not know how this breaks, numbers-wise. I mean, I do not know what proportion of the bad paper is directly due to the GSE’s actions.

    But there is a larger sense in which the 1995 revision and the GSE’s behavior may have fanned the flames of private behavior. If the initial experiments of subprime securitization under the revisions, from about 1997 to 2001, were viewed as successful and safe by observers, then they had a sort of demonstration effect to everyone else. If the government says to banks: “Go and make subprime loans to the riskiest possible borrowers” and the thing isn’t an immediate fiasco, then it could well have changed views about what kind of lending is “normal, customary and safe.”

    And of course, I think it is important to remember that events following the 2000-2001 recession and the dot-com bust poured fuel on the fire (this is the tinder I referred to above). The Fed took interest rates down near zero, which makes capital assets like houses appreciate and also makes it cheaper to finance them. And the dot-com bust released a lot of smart money from the stock market, which went into…real estate investment trust.

    Once a bubble gets going, everyone–investors, home buyers, banks and finance firms–become creatures of the bubble. There’s a severe epistemic problem with bubbles. There are always “real” reasons why assets can appreciate. So everyone is in the position of not knowing for sure the truth value of the statement “this is a bubble.” If you think a trend in asset prices reflects real factors, it is sensible to get on board. Even if you don’t, it is sensible to get on board if you think most other people think the bubble is real.

    In the theory of games, games frequently have multiple equilibria. And if there is “strategic uncertainty”–which means the players aren’t certain how other players behave–the scope for multiple equilibria, including bad and destructive ones, just grows.

    I do think we can point to several events that facilitated the establishment of a bubble. The CRA revision; the recession and dot-com bust, and resulting low interest rates and money freed up; and the “bad social learning” that brought financial firms and lenders to view subprime/securitization as a normal and customary thing.

    But once the bubble got established, it took on a life of its own–a web of mutually reinforcing beliefs and actions–quite independent of these things. At that point, everyone, or no one, was to blame.

  3. shellbell858 | 2008-Sep-30 at 17:00 (@750) | Permalink

    i agree, and those changes proposed in 1995 were a multi-agency bipartisan effort. Changes to many things, not just the CRA brought about the crisis.

    Did you mention the 2004 changes that reduced the banks regulated by the CRA by 50%? It also included stricter anti-predatory lending restrictions to the remaining 50% but again, it cut the banks covered in 1/2 so that MORE banks could greedily participate in the predatory lending without worring about the regulated CRA.

  4. DaveC | 2008-Oct-01 at 07:24 (@350) | Permalink

    NTW and Charlie..

    Thank you for the postings and research..

    one would never get this from newspapers or MSNBC…

  5. shellbell858 | 2008-Oct-01 at 09:59 (@457) | Permalink

    MSNBC has in fact noted the points made by NTW to counter FOXnew and other conservative media’s blame of the recession on the CRA. I watch both, because both are inappropriately extreme in opposite directions and because NEITHER provide the whole story. What I like about MSNBC is that you clearly know you are getting a biased opinion, what I don’t like about FOXnews is they claim to provide an unbaised opinion but clearly have a biased opinion. To me, deceptive biased reporting is worse than transparent biased reporting. Either way it’s important to do your own research and not rely soly on either forms of media.

  6. NTW | 2008-Oct-01 at 17:56 (@789) | Permalink

    Here’s a somewhat different angle on the “bad social learning” idea by Malanga over at Real Clear Markets. I don’t necessarily agree with his punchline, but I wasn’t aware of the effort (through the Boston Fed) to convince banks that the received customs and wisdom about credit worthiness were wrong. Interesting.

  7. NTW | 2008-Oct-01 at 18:00 (@791) | Permalink

    I would add: Is “20% down or no loan” one of Kipling’s Copybook Headings? ;)

  8. Charlie | 2008-Oct-01 at 21:39 (@944) | Permalink

    The Act was passed in 1977, are you telling me the subprime lending wave that hit from 2004-2007 was because of a 1977 law? That doesn’t mathmatically nor logically make since.

    True, but then I didn’t say that, either. You really need to be careful with those straw men. What I said was that, starting with the CRA in 1977, we started to force banks to make higher risk loans at the same interest rates as lower-risk loans. As NTW points out, changes in 1995 increased the problem; some, um, aggressive accounting at Fannie and Freddie, plus political pressure to increase the number and proportion of those loans, increased it even more.

    …blame of the recession on the CRA

    Sheli, if you think I’m blaming a recession on the CRA, you’ve misread. But this more limited notion — that the CRA and other market distortions led to the issue of higher risk mortgages — isn’t even controversial. In fact that was a stated purpose of the law: to ensure that people who were a greater credit risk, didn’t have a large downpayment, or were buying in high risk areas got loans anyway. These are, almost by definition, higher risk loans.

    The structure of things built up to share the risk of these higher risk mortgages, along with the fairly draconian mark-to-market instantly rules from FAS 157, together set up the dominoes for this current issue, which may lead to a recession.

    NTW, there’s nothing magic about 20 percent down. It does mean that someone has more skin in the game and more to lose in a default. But the trade of risk and cost doesn’t have some magic special value at 20 percent down; if a zero-down loan is at an appropriate interest rate, and it fits your level of risk tolerance, there’s no reason not to write one.

  9. NTW | 2008-Oct-02 at 06:06 (@296) | Permalink

    Shellbell, I should say that Charlie’s narrative of events makes a lot of sense to me. Mostly, I see some question marks about the right counterfactuals (always a problem in assessing causality without a true experiment) and about some specific numbers–how mortgages break between GSE-guaranteed ones and purely private ones.

    Here’s another interesting article this morning:

    Hubbard and Mayer have actual research credentials in academic economics. This is the first extensive proposal for stabilizing the housing market that I’ve seen offered by such people.

    It also has some numbers. They claim that the Feds now control 90% of the mortgage market. Does that mean that the GSEs were holding 90% of U.S. mortgage paper when they went into conservatorship? Or that they back 90% of all outstanding mortgages?

    I’m just asking. I would really like to know what the relevant numbers are. Without that, it is hard to know how to assign responsibility between the private and public sectors here.

  10. billshaw | 2009-Mar-01 at 18:06 (@796) | Permalink

    Concise Explanation with Blame Assigned.
    There’s a great deal of bias in the attempt above to explain the financial meltdown. It has been repeated mindlessly that banks were “forced” into making subprime loans. No one, however, speaks with any knowledge of these forced loans, or cites statutes/bank regs, or any other authority. Where are the details? Someone is trying to make us believe that a bank charter will be revoked unless the institution makes a certain percentage of sub-prime loans. That’s lazy talk and just plain wrong.

    The 1977 CRA was designed to prevent financial institutions from totally ignoring applicants from certain “red lined” areas. It was an effort to eliminate blanket racial discrimination.

    The 1995 amendments to CRA were passed after the Newt Gingrich take-over of Congress and after the Republican Congress shut the government down. The writer of the “Concise Explanatsion” comment may have misplaced that bit of information.

    Political cronies footnote — Who are those people? Are we supposed to guess?

    Lobbying — Are we to believe that only Democrats received lobby money. Ever heard of Abramoff? Randy Cunningham? What about Bob Ney, Republican-Ohio doing 30 month prison time for Abramoff. What about Tom Delay’s forced resignation for ethics violations. Ted Stevens, Republican-Alaska. Heard of him?

    Mark-to-Market accounting only requires securities to be recorded at their current value. A lot of people think that assets should maintain their “book” values until the market comes back in a few years, but any professional financial examiner could see through that. Example: If your house has lost $50,000 in value, but you keep your job and hold on, it will probably come back and maybe exceed that. But financial institutions are not like that. They have to meet their reserve requirements, and their portfolio of securities as simply marked to their market value. Otherwise their true net worth would be misstated.

    Don’t be protective of credit rating agencies — Fitch, S&P, Moody’s. First of all, they decline to answer my inquiries regarding their connection to investment firms . They are, after all, compensated by Wall Street for their servicies. Their is some possibility they were pressured into giving AAA ratings to securitized debt obligations when they knew the risk was much higher.

    Sure, very many firms found themselves strapped when they became liable on the derivatives (credit default swaps). AIG, the big insurer, certainly ought to have known better. All of them were greedily raking in the profits before the bubble went pop. Whoes fault was that? Not the taxpayers?

    Some people like to say that even the higher-ups in investment banking and hedge firms didn’t really understand the complexities of these newly invented financial instruments. Heck with that. They’re the ones who invented those things. They were making money, and either assumed the bubble would never bust, or that they would get out with their fortune/reputation before the disaster.

    The writer of “Concise Explanation” obviously has an ax to grind with nothing but hot air to back up his arguments. If you are looking to place the blame, you have to mention Robert Rubin, Clinton’s Secretary of Treasury, Clinton, George W. If W warned of the problem 18 times as “C.Ex” claims, why didn’t he do something? He had a Republican Congress for 6 years that ate out of his hand. You can also put former Senator Phil Gramm (Mr. Deregulation), Alan Greenspan, and Christopher Cox (Bush’s SEC chief) on the blame list.

  11. Charlie | 2009-Mar-01 at 18:34 (@815) | Permalink

    Good lord, Bill, it’s been six months since this was posted. how’d you even happen upon it?

    Re the 1977 CRA: doesn’t matter. The effect was to increase the risk while forbidding banks to modify interest rates.

    Re the 1995 amendments: I don’t recall noticing that there was a constitutional amendment allowing the Congress to pass things over Clinton’s objections. In any case, check the legislative history: it was proposed by Clinton.

    Re cronies: there is plenty of other information on this if you care to look around. Some names you might start with are Gorelick, Raines, Emanuel, Rubin — the people who got rich in the private sector having left the Clinton administration.

    Re lobbying: nope, but it’s well documented who received by far the *most* lobbying money on banking issues: Schumer, Kerry, Clinton, and Obama are four of the top five.

    On mark to market: the “true net worth” issue is the problem. In the middle of a panic, when some companies have been forced to sell at fire sale prices, FAS 157 fores their on-paper net worth down, very probably artificially. Why is that more the true net worth than any other?

    If I sounded protective of the rating agencies, it wasn’t my intention: they clearly didn’t do a good job either of understanding the securitized stuff or of evaluating the risk.

    As far as the losses that killed AIG, nope, wasn’t the taxpayers fault at all. But one of the things I learned in first aid class was they you stop the bleeding first, and then inquire into the cause of the accident.

    If you want to convince me that Phil Gramm had much to do with it, you’re going to need to tell me what regulation was removed; it’s unclear Glass-Steagall changes had much to do with it.

    On Cox, look at the date again; in September it wasn’t much less clear what happened and how much the SEC had to do with it.

    And on the eighteen times issue, the names you’re looking for are “Barney Frank” and “Chris Dodd.” Contrary to what a lot of people apparently think, having a small majority in Congress doesn’t lead to the ability to force Congress to pass anything you want. Hell, as Obama is finding out, even a large majority doesn’t always mean you get what you want.

  12. billshaw | 2009-Mar-04 at 08:36 (@400) | Permalink

    Quite frequently, pundits will find the origin of the problem as far back as the Carter administration that advanced the Community Redevelopment Act (CRA), and that banks were pressured into making sub-prime loans. The principal focus of the Act, however, was to eliminate “red-lining,” the practice of many lending institutions of refusing to finance businesses and housing in certain urban areas. These were typically minority and impoverished areas.

    Were banks pressured into making sub-prime loans? The pressure banks have been subjected to evidently stems from the long-standing principle that insured depository institutions must serve “the convenience and needs” of the communities in which they are chartered to do business. This includes meeting the credit needs of that community. The Bank Holding Company Act (1956) required the FRB, when reaching decisions on proposed acquisitions by banks or bank holding companies, to evaluate how well they were involved in meeting community needs, consistent with the requirements of safety and soundness. This is the basis for the arguments of some critics that the CRA obligation is the quid pro quo for privileged access to federal deposit insurance and access to the Fed’s discount window.

  13. billshaw | 2009-Mar-07 at 19:54 (@871) | Permalink

    The Federal Reserve Board: Countrywide and others were given an open door to engage in exploitive and deceptive business practices by the conduct – or rather the omissions — of the Federal Reserve Board. It is rather as if the Fed was expecting A (highly ethical conduct by a deregulated financial market) while rewarding B (exploitive and deceptive practices). The Fed kept interest rates at a historically low level and declined, until July, 2008, to exercise its authority to prohibit abusive, unfair, and deceptive practices. In a world led by an ideology of deregulation, House Banking Committee Chairman Jim Leach (R-Iowa) asked “. . . is the Federal Reserve AWOL?”
    Wall Street: Investment banks and private equity funds facilitated questionable business practices by exhibiting a thirst for highly rated mortgage-backed obligations (MBOs). The AAA stamp of approval gave these institutions the opportunity to borrow freely with nominal amounts held in reserve. A 30 – 1 debt/equity ratio which prevalent during the period 2004-06 gave Wall Street an abundance of cash to purchase more MBOs.
    Triple A ratings, one would think, would be hard to come by. Instruments of that degree of security require fewer assets to be held in reserve. As it turns out, the gatekeepers of these ratings – Moody’s, Standard & Poor’s, Fitch were in the pay of Wall Street bankers who thrived on leverage. If a 30 – 1 ratio was good, wouldn’t 40 – 1 be better? The fee between the rating agencies and the bankers was held in abeyance until the securities were sold, and the sale of mortgage-backed securities was facilitated by a AAA stamp of approval. Hence, 80% of the pooled mortgages (the securitized debt obligations) were labeled AAA.
    This abundance of Wall Street cash primed the pump for Countrywide, New Century, and Ameriquest. The loan officers of these firms, and independent loan brokers, received bonuses for inducing borrowers into mortgages that were riskier than they could have qualified for otherwise. This is called the yield-spread premium (YSP), a practice still unregulated by the Fed.
    Brokers and loan offices could maximize their bonuses by including a pre-payment penalty. These clauses were typically high enough to discourage or prevent refinancing. Before the housing bubble burst, however, neither the pre-payment penalty nor increased future payments on adjustable rate mortgages (ARMs) inhibited sub-prime financing. Borrowers who were concerned with increased payments would be told not to worry, they could always refinance. Following the downturn, efforts to work out terms amenable to the economic realities of many borrowers did not make a great deal of headway at Countrywide. However, as recently as March 5, 2009, the House passed a measure that would give bankruptcy judges the power to adjust some mortgages. It remains to be seen how this measure will fare in the Senate, but, if it becomes law, mortgage-holders (holders of mortgage-backed securities) may be more willing to enter voluntary re-negotiations.
    The Rating Agencies (Fitch, S&P, Moody’s): It is the role of credit rating agencies to evaluate the market worth of investment instruments, and to do it objectively. The objectivity of this process has been a matter of contention since the program’s inception. After all, the ratings are done on a fee basis, so the possibility of pressure being exerted by the client is a matter that calls for transparency. That issue has, of course, been exacerbated by the onset of the current recession.
    The web sites of each of these firms acknowledge the potential for such conflicts, and link the reader with the firm’s efforts to put the matter to rest. For example:
    “The real question is not whether there are potential conflicts of interest in the ‘issuer pays’ model, but whether they can be effectively managed. Mr. Erik Sirri, director of the SEC’s Division of Market Regulations, last year testified at a congressional hearing that the conflicts raised by this long-standing business model are indeed manageable. Taken together, we believe these measures provide robust safeguards against the potential conflict of interest inherent in the “issuer pays’ model.”
    Despite these efforts, some questions regarding the objectivity of these rating have not been laid to rest. Email exchanges between employees of these rating agencies indicate that some insiders suspected that the standards were too easily gamed, and that this would lead to bigger problems down the line. A 2006 Standard & Poor’s email raised questions about the impact of its ratings on mortgage-backed securities and credit default swaps: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”
    American International Group (AIG): Mortgage-back securities held by troubled banks were given AAA ratings by Moody’s, S&P, and Fitch. The AAA ratings were supported by the additional protection of credit default insurance (credit default swaps). These were being issued by AIG, the world’s largest insurance company. Unlike the highly regulated insurance industry which includes AIG’s traditional line of business, the market in swaps is unregulated. Based on the strength of AIG’s AAA rated balance sheet and the AAA rating granted to the bonds by the rating agencies, it was widely believed that there was almost no risk that the AAA rated bonds would default.
    Banks were required to set aside virtually no capital reserves against AAA holdings. Consequently, banks could add assets and leverage to their balance sheets without the burden of committing more regulatory capital. This arrangement was favorable to other regulated entities, including foreign banks, and led to a highly levered, tightly inter-related global financial system.
    The American International Group (AIG) reported 62 billion in losses in 4th quarter, 2008. That’s largest quarterly loss posted by any firm ever. Greed, or an abysmal failure of judgment?
    “Greed is Good” according to Gordon Gekko, played by Michael Douglas in the 1987 Oscar-winning film “Wall Street.” But Gekko broke the law and paid a price. AIG didn’t break the law. It gamed the system. Everything it did was legal and in plain sight. Since it was to-big-to-fail, the essence of a moral hazard, the federal government (proxy for U.S. taxpayers) stepped in and bought approximately 80% of its stock. The price, or the price so far, is $150 billion, but there is something like another $100 billion in debt in the wings if the housing market doesn’t stabilize. The AIG stock price, by the way, is 42 cents a share.
    How did this happen under the nose of U.S. regulators? Simple. There are no regulations in the game AIG played.
    AIG’s history as an enormously profitable and well-run firm gained it a AAA rating from the most prominent agencies – Fitch, S&P, Moody’s. Lured by large fees, AIG used its rating to bless securitized debt, i.e., mortgage-backed securities that had been pooled and sold to investment banks and private equity funds. These firms would in turn use these mortgage-backed securities to borrow still more money to invest in . . . mortgage-backed securities.
    The strategy was fool-proof, but only if the housing market continued strong and on the up-turn. That didn’t happen of course. The reason the market crashed was the weigh of billions of dollars in “toxic” mortgages. These mortgages stemmed from Countrywide-like firms that “forced” sub-prime mortgages on borrowers who were by no means able to make the scheduled repayments. Since housing prices were assumed to be on a strong upward surge, borrowers were told that if they defaulted, then the mortgage could simply be re-negotiated. After all, with housing prices on the upswing, the appreciation in home values would easily underwrite the debt.
    Securitized debt instruments were created by dividing the pooled mortgages into tiers, or stanches. Actually, these are “mixed bags.” The strongest tiers carrying the fewest toxic instruments, the second tier with more, and the bottom tier loaded with toxic, sub-prime mortgages. The demand for these securitized debt instruments was so high that Countrywide and other mortgage brokers went scurrying to create more and paid handsome bonuses to employees and associates for brokering more deals.
    AIG enters the picture, not by issuing securitized debt, but by selling derivatives called credit default swaps (CDS). These derivatives (CDS) lent AIG’s AAA rating to instruments that were built on a house of cards, that is, built in large part on toxic mortgages. Derivatives are instruments that bring in fees — high fees — and will be paid off if such conditions are met. In this case, the conditions provided for AIG to pay its customer if the securitized debt instruments that were being “insured” went below a cretain point.
    Insured is not quite the right word because state regulated insurance law requires a certain amount in reserves be set aside in the event the terms of a policy are triggered – fire, flood, accident, death. Credit default swaps, however, are not regulated. That meant AIG was not required to set aside any amount to support its obligations in the event of a housing down turn. But for an additional fee, AIG would agree to put up collateral if it, or if the securitized debt it was backing up, received a rating down grade.

  14. Charlie | 2009-Mar-18 at 07:25 (@351) | Permalink

    Bill, seriously, I think you should get your own blog. You’re writing these long comments on a six month old post on an obscure blog I haven’t been able to even update much because of illness. I’ll be happy to help you find an appropriate set up, but you’re not even having a conversation with me because the of the same illness.

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