Western Asset Mortgage Capital's CEO Discusses Q3 2013 Results - Earnings Call Transcript

| About: Western Asset (WMC)

Western Asset Mortgage Capital Corporation (NYSE:WMC)

Q3 2013 Earnings Call

November 7, 2013 11:00 am ET


Larry Clark - IR

Gavin James - CEO

Steve Sherwyn - CFO

Anup Agarwal - CIO

Bonnie Wongtrakool - Portfolio Manager

Ben Hunsaker - Portfolio Manager


Rich Shane - JPMorgan

Mike Widner - KBW

Daniel Furtado - Jefferies

Steve DeLaney - JMP Securities


Welcome to the Western Asset Mortgage Capital Corporation's Third Quarter 2013 Earnings Conference Call. Today's call is being recorded and will be available for replay beginning at 5:00 PM Eastern Standard Time. At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following the presentation.

Now first I'd like to turn, the call over to Mr. Larry Clark, Investor Relations for the company. Please go ahead, Mr. Clark.

Larry Clark

Thank you, operator. I want to thank everyone for joining us today to discuss Western Asset Mortgage Capital Corporation's financial results for the three months ended September 30, 2013.

By now, you should have received a copy of today's press release. If not, it's available on the company's website at www.westernassetmcc.com. In addition, we are including an accompanying slide presentation that you can refer to during the call. You can access these slides in the Investor Relations section of the website as well.

With us today from management are Gavin James, Chief Executive Officer, Steven Sherwyn, Chief Financial Officer, Anup Agarwal, Chief Investment Officer.

Before we begin, I would like to review the Safe Harbor statement. This conference call will contain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are intended to be subject to the Safe Harbor protection provided by the Reform Act.

Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of the company. All forward-looking statements included in this presentation are made only as of the date of this presentation and are subject to change without notice.

Certain factors that could cause actual results to differ materially from those contained in the forward-looking statements are included in the Risks Factors section of the company's reports filed with the SEC. Copies are available on the SEC's website. We disclaim any obligation to update our forward-looking statements unless required by law.

With that, I will now turn the call over to Gavin James, Chief Executive Officer.

Gavin James

Thanks, Larry, and thank you everyone for joining us this morning for our third quarter conference call. I will begin the call by providing some opening comments. Steve Sherwyn, our CFO, will then discuss our financial results. And then Anup Agarwal our new Chief Investment Officer will provide an overview of our investment portfolio, our liability profile, and our future outlook. After our prepared remarks we will conduct a brief question-and-answer session.

During the third quarter we recorded net income of $0.31 per share while generating core earnings of $0.83 per share and declared a $0.90 per share regular dividend.

This was very much a tale of two quarters. During July and August we continued to see a high level of volatility in the mortgage market, as 10-year treasury rates increased on the belief of a Fed tapering was eminent. During the first two months of the quarter we experienced a decline in our book value adjusted for dividend payments of approximately 9%.

Despite the record rise in interest rates we largely stayed the course with our longer-term strategy making only modest changes in the portfolio in response to market conditions. In September, as weaker economic phase emerged and the Fed announced that it would be initiating a tapering of its asset costing program, we saw a decline in rates of the 10-year and a corresponding recovery in the agency RMBS market. We were well-positioned to capitalize on the shifting sentiment and our book value increased by more than 6% during the month of September, again adjusted for dividend.

For the entire quarter, our net book value declined approximately 3% to $16.81 as of September 30, 2013.

From the perspective of total economic return on book value, which is calculated by the change in book value plus the dividends, we delivered a positive return of 1.8% during the third quarter.

Including our third quarter results we have continued to generate a significant level of outperformance growth through our peer group. Since our IPO offering in May of 2012 through September 30, 2013, we have delivered an economic return of 9.6% which is well in excess of the average of agency RMBS peers over that same timeframe.

Since the beginning of the fourth quarter we have seen a continuation of the trends we experienced in the month of September, which has had a positive impact on the value of our portfolio.

Given the lower level of volatility we've seen in the agency RMBS market over the past two months, we believe we are in a more conducive environment for maintaining great visibility in our book value, while continuing to generate a strong level of core earnings.

Our current view on interest rate is that the long end of the curve will remain range bound over the next six months and short-term rates will remain near zero. This view was based on our belief that economic growth in the U.S. will remain subdued over the next several quarters likely in the 1.5% to 2% range. We do not believe that the economy will materially weaken although we expect it accelerate at any time soon.

This middle of the road view on the economy should lead to low interest rate volatility and more stable agency MBS values. Additionally, the slow but steady growth in the economy should be a good environment for credit spread investments and contributes to our positive view on non-Agency security. We also expect to see continued house price appreciation in this part of the economy albeit at a much reduced pace from what we have seen in the last 18 months. As it remains, we could be able to pent-up long-term demand for housing and affordability will remain attractive.

As we announced in September we've appointed Anup Agarwal as our new Chief Investment Officer to take the place of Steve Fulton who has retired from the investment management industry. Anup joined Western Asset Management Company earlier this year, as Head of Non-Agency MBS and ABS and has also taken on the position of Head of Agency MBS following Steve Fulton's retirement.

With more than 15 years of experience in securities analysis and investment management Anup has an excellent track record in mortgage funds. His extensive experience in management both Agency and non-Agency mortgage investment strategy, which is particularly valuable given our current investment outlook, which at this time improves increasing our exposure to non-Agency securities.

We are very pleased to have him on the REIT team and he will walk through some of the specifics of our portfolio a little bit later on in the call.

At this time, I'm going to turn the call over to Steven Sherwyn, our CFO to discuss our financial results. Steve?

Steve Sherwyn

Thanks Gavin. Good morning everyone. I will discuss our financial results for the third quarter ended September 30, 2013. Expect where specifically indicated all metrics are as of that date. On a GAAP basis we earned net income for the quarter of approximately $7.5 million or $0.31 per basic and diluted share. Included in the net income was approximately $37.5 million of net realized gain on MBS and approximately $48.5 million of net realized loss on MBS and approximately $4.4 million of net loss on derivative instruments and link transactions.

For the quarter, our core earnings, which is a non-GAAP number defined as net income or loss excluding net realized and unrealized gains and losses on investments. Net unrealized gains and losses on derivative contracts and non-cash stock-based compensation expense, one-time events pursuant to changes in GAAP, and other non-cash charges was approximately $20.1 million or $0.83 per diluted share.

Our net interest income for the period was approximately $26.4 million. This number is a GAAP number and does not include the interest we received from our IO securities that are treated as derivatives, nor does it take into account the cost of our interest rate swaps both of which are included in the loss on derivative instruments lying in our income statement. On a non-GAAP basis our net interest income including the interest we received from IO securities treated as derivatives, interest we received from linked transaction, and taking into account the cost of our hedging was approximately $23.4 million. Included in this calculation was approximately $50 million of coupon interest offset by approximately $16.2 million in net premium amortization and discount accretion.

Our weighted average net interest spread for the quarter, which takes into account the interest that we receive from non-Agency RMBS, and IO securities, as well as the fully hedged cost of our financing was 2.28% reflecting a 3.42% growth yield on our portfolio at a 1.14% effective cost of funds.

Our cost of funds increased 18 basis points compared to the second quarter, which is primarily attributable to the increased hedging we put in place in the prior quarter in response to the higher volatility we saw in May and June and which continued through August.

Our operating expenses for the period were approximately $3.5 million, which includes approximately $1.5 million of general and administrative expenses, and approximately $2 million in management fees.

Our net book value decreased by approximately 3% during the period from $17.39 on June 30, 2013 to $15.81 on September 30, 2013. Anup will go into further detail on what primarily drove the decrease in book value for the quarter.

Our economic return for the quarter was a positive 1.8% which we've previously noted represents a change in book value plus the dividends and which includes a third quarter dividend of $0.90 per share.

As Gavin mentioned earlier the approximate 16.5 months since our IPO through September 30, 2013, we would generate an economic return of approximately 9.6%.

During the third quarter, our constant prepayment rate or CPR for our Agency RMBS portfolio was 5.3% on an annualized basis. This compares to 4.4% for the second quarter of 2013. We believe our CPR continues to remain low due to our focus on buying securities that exhibit low prepayment characteristics.

As of September 30, the estimated fair value of our portfolio was approximately $3.6 billion and we had borrowed a total of approximately $3.3 billion under our existing financial repurchase agreements. Our leverage ratio was approximately 8.1 times at quarter-end. Our adjusted leverage ratio was approximately 9 times at quarter-end adjusted for $390 million notional value of net long positions in TBA mortgage pass-through certificates that we held at the end of the quarter. You may recall that at the end of the second quarter we held a net short TBA position in the notional amount of $500 million so both the quarter-to-quarter net swings deposited of approximately $890 million in notional value of TBAs, which lead to an increase in our adjusted leverage from 8.2x to June 30 to 9x at September 30. Our stated leverage decreased during the quarter going from 9.4x at June 30, 2013 to 8.1x at the end of September.

We continue to be in the attractive position of having repo capacity in excess of our need. At September 30, we had master repurchase agreement with 18 counterparties and outstanding borrowings of 17 parties. We continue to receive offers to expand our repo line from these and other institutions. At the present time we feel comfortable with our existing counterparty. We have a highly diversified repo lender book and believe that we have more than ample liquidity to meet our present and future expected requirement.

With that I will now turn the call over to Anup. Anup?

Anup Agarwal

Thanks, Steve. Good morning. And thank you for joining us today. Before I begin my prepared remark, I would just like to kind of say how honored I am to be leading the agency mortgage and structured product investment teams here at Western Asset and to be heading the investment team for WMC. In the time that I have been here, I have been thoroughly impressed with the deep experience across the investment teams at Western Asset, as well as the level of professionalism and commitment to delivering superior results. I believe that our team of investment professionals is among the best in the industry and that's one of the primary reasons I joined Western and also why I believe the REIT has been able to hard perform its peer group since its idea in May of 2012 and what has at times been a very challenging environment for our mortgages. Let me spend a few minutes discussing our portfolio and then I would like to talk about our outlook going forward.

As indicated earlier, despite our declining book value for the quarter, we delivered a 1.8% economic return when taking into account our dividend, which was the result of our ability to continue generating strong quarter earnings. The decline in our net book value during the quarter was primarily due to a decline in MBS values in the first two months of the quarter and some portfolio rebalancing action that we implemented throughout the quarter as we shifted our -- some of our look upon agency 30 year fix rate mortgages and increased our capital allocation through non-agency RBS.

We believe that in the current market environment these securities offer attractive risk adjusted returns and can serve as a compliment to our existing agency RMBS holdings. We maintained our relative allocation to 20-year pools during the quarter as we continue to believe they remain attractive from spread duration and evaluation perspective. Our portfolio benefited from the rally and MBS during September, but not enough to offset the decline in book value that occurred through August.

On the liability side of our balance sheet, we excited our large swaps and positions early in the quarter and replaced them with interest rate swaps that accomplish the same goal of reducing portfolio duration for our more cost effective in the current market environment of the low interest rate volatility.

As Steve mentioned, our net TBA positions changed rather meaningfully during the quarter. We started the quarter in net short position of $500 million notional value of TBA securities. We settled the position early in the quarter. Later in the quarter, we moved to a net long position in TBA securities and ended the quarter with net long position of $390 million in notional value.

Our activity in TBA market is due to our desire to adjust our portfolio leverage and exposure to agency RMBS without having to immediately buy or sell the spec pools at the time we decide to make market -- make portfolio reallocation.

With that, let me turn to some of the portfolio details as of the end of the third quarter.

As of September 30, 2013, the total estimated market value of our portfolio was approximately $2.6 billion and consisted primarily of agency mortgages complemented by holdings in non-agency RMBS and agency and non-agency IOs and Inverse IOs. During the quarter, we added for the first time a small amount of CMBS securities and at the appropriate time we look to increase our holdings of these securities going forward based on our view of their expected risk adjusted return profile.

Our portfolio remains weighted towards 30 year fix rate mortgage pools, which represented approximately 54% of the value of the total portfolio. Our exposure to 20-year fixed rate mortgage pools at quarter end was approximately 19%, non-agency RMBS represented approximately 7% of our portfolio. Agency and non-agency interest only scrips and inverse interest only scrips represented 8% of total and agency and non-agency CMBS, including IOs and Inverse IOs represented just under 1% of the portfolio.

If you break down our agency specified pools by sector, 52% of the total was invested in mortgage pools with MHA loans with high LTV and the next largest factor was pools with low loan balances at 38%, which is consistent with our investment strategy of minimizing our retainment risk. The remaining 10% consists of pools representing new issuance and low WALA, high SATO or spread at origination and low third party origination loans.

Our weighted average loan age or WALA for agency portfolio was 11.6 months. We believe that managing our WALA ramp is another component towards keeping our prepayments low.

As Steve noted, our CPR was 5.3% for the quarter, which compares with an average of around 17% for our agency peers and has contributed to our higher than peer average rose effective yield on the portfolio.

Now, turning to the liability side of our balance sheet. As Steve mentioned, we have funded our portfolio through the use of short term repurchase agreements, our repos. As of September 30, we have borrowed $3.3 billion under these agreements, resulting in leverage of approximately 8.1x prior to adjusting for our $390 million net long TBA position that we carried at quarter end.

As of September 30, we had entered into approximately $2.7 billion in notional value of interest rate swaps. Our swap positions represented approximately 83% of our outstanding funding. The swap contracts range in maturities of between 12 months and 29 years with weighted average remaining maturity of 8.6 years and there a weighted average fix rate of 1.9%. Approximately 27% of the notional value of these swap positions are held in over starting swaps, that start approximately 6.3 months forwards. As a result, our agency portfolio had a net duration of approximately 1.1 years at quarter end.

At current time, we view duration risk as a primary risk to our portfolio which we believe we are managing through distribution of our hedges throughout the yield curve. While the net duration of our portfolio remains modestly positive, the majority of that positive duration has been at a shorter end of the yield curve and we have maintained a slightly negative duration at the long run.

We are comfortable with our current leverage but as we expand into more credit product, we would expect it to decrease. We determine our leverage based on what we believe will enable us to optimize our core earnings on the risk adjusted basis and maintain our relatively stable book value. Our size and our ability to be nimble allocators of capital allows us to respond quickly to changing market condition, including changing portfolio mix and duration gap. Essentially, our primary investment strategy remains unchanged, that is to buy all protective securities that offer the best risk adjusted carry and hedge them over an interest rate cycle. That said, as opportunities present themselves, we currently expect to increase our exposure to non-agency securities, CMBS and ABS through our allocations that these asset classes will vary based on market conditions.

We are confident that over entire economic cycle, we will be able to generate a consistently strong dividend from our -- for our shareholders while maintaining a stable book value.

With that, we will now entertain your questions. Operator, please open the call.

Question-and-Answer Session


Thank you, sir. Ladies and gentlemen, we will now begin the question and answer session. (Operator Instructions).

Our first question comes from the line of Rich Shane with JPMorgan. Please go ahead sir.

Rich Shane - JPMorgan

One question and one comment. I will start with the comment. The partial duration information you guys provide is incredibly helpful, so thank you for that. We wish it would become more standard across the industry. The question is the following. Given what is happening with credit in the non-agency markets and frankly increased competition for those assets, how do you feel about that opportunity? I think that you're starting to see greater and greater correlation between those assets and interest rates. Does that diminish, in your mind, at some point that opportunity?

Anup Agarwal

Sure, I think -- great question. Look I think spreads have tightened or the yields have tightened non-agency market, but I think our selection for the area of non-agency which we have focused on has being -- or where we have been shifting our portfolio too within non-agencies have been more on alt A securities or (inaudible) securities, specially the securities which will benefit greatly from continued HPA growth. And we kind of think that the optionality of better recybility of underlying borrowers is still not fully priced in. And as -- in our mind, as we see the lending market confuse to get better, I think we will see that we will realize better refinancing which will result into significantly better yield and total return realized on those securities.

Given, your point is very fair and we have been very, very selective within non-agency market where we want to stay.

Richard Shane - J.P. Morgan

Got it. A peer company today observes that there is anomaly where jumbo prices are actually below conforming prices. How do you think that impacts your opportunity?

Anup Agarwal

(inaudible) I think within --

Richard Shane - J.P. Morgan

And I mean jumbo yield, excuse me?

Anup Agarwal

Yes I mean I think this is again I am assuming that this is primarily for non-agencies.

Richard Shane - J.P. Morgan


Anup Agarwal

I mean, I think look even with the jumbo yields where they are, I think the bed in non-agency is still driven by these borrowers being able to refi just simply because significant percent of these borrowers had higher than 100 LTV at given -- at three years, four years back and lot of these borrowers have been able to have their LTV come down below 100. And as it does lot of these borrowers, these are still Hybrid ARM borrowers and ultimately, they have a better chance of being able to refi versus having the adjustable rate mortgages.


Our next question comes from the line of Mike Widner with KBW. Please go ahead.

Mike Widner - KBW

I have two questions and I guess the first one is, may be if you could talk a little more about how you see the shift of the increasing allocation toward non-agencies progressing? And I think you do look at better 11% your assets are there today. But I mean as far as capital allocation and how you view that opportunity relative to the opportunity in agencies right now, I just wonder if you could talk a little more about that?

Anup Agarwal

Sure. I mean I think -- look I think the way we evaluate all these opportunity is look I think our thought process is always is to look for where we see the best relative value and shift the allocation. So right now, we still see, we have flexibility to increase allocation to non-agencies. But again, it is very dependent upon to be continuously value in the marketplace, specially focusing again at the securities which benefit from continued increase in lending market for underlying borrowers. If -- ultimately, we kind of see that we are not able to either find those securities or the yield does not exist, I think you would kind of see us back away.

Mike Widner - KBW

So -- and it maybe just to get a little more specific. I mean for -- as you are looking for opportunities in non-agencies right now, I mean how you are looking at the economics that you need to see for that to be attractive? I mean, whether on an ROE basis or an asset yield basis or however, you want to look at. I guess just -- there is obviously a wide range of stuff out there, and so I was just wondering if you could elaborate a little more on sort of the threshold is?

Anup Agarwal

Yeah, sure. I mean look I think on non-agencies I think our threshold really where will kind of see the attractiveness of the marketplace and these are the securities which have the yield range of 6.5% to 7.5% and where we kind of see the cash and cash yield is better than that yields the maturity range. And the -- and we kind of think that if the underlying borrower profile continues to improve, we will see better than that realized yield. I also have Ben Hunsaker with me. Ben do you agree, do you have anything else to add?

Ben Hunsaker

Yeah, I would agree with that statement. We think about our non-agency allocation, we are not thinking about the net return profile. As we do fund essentially across the broader portfolio holding, we think about the cash flow return profile that is specific to non-agencies and the realizable cash on cash deal that match with the counter balances what the agency cash flow profile might be different (inaudible).

Mike Widner - KBW

So its interesting because you guys are talking about moving more towards non-agencies but relative to what a lot of peers have done, you have moved I'd say substantially slower in that direction than a lot of others and it is sort of interesting because everyone is kind of -- again, if we look across the sector there has been pretty substantial sales of agency assets and a lot of talk about we're getting more into the non-agency business. And you guys is taking a little bit different approach. You really have not reduced to overall leverage profile much, you still appear to favor. All things considered, you -- I do not want to say necessarily favor agencies but you are clearly very heavily weighted there. And I guess one reason might -- we might see why is if I just take your core earnings for the quarter, I mean you are running 20% and so ROE on mostly agency book. So I mean that is awfully high threshold to try and meet if you are going to sort of run, try and reallocate the portfolio materially to non-agencies. So I guess when it really comes down to then my question is, clearly you're seeing something different than the environment then what most of your peers are and then you're behaving accordingly. And I guess, I am just wondering if you could articulate that a little more, I mean clearly you do not seem to have the rate fears or the QE unwind fears that the others do and I guess I am just interested in why?

Anup Agarwal

Yeah, I mean, look I think it is -- part of it is just -- a big part is driven by our economic outlook and we really do not see interest rates rise quickly. And I think that our view of the economy really is kind of just middle of the road, kind of GDP growth in the -- in our view that middle of the road GDP growth kind of results into significantly better, it is very bullish for credit spread products and that is -- but still kind of as you mentioned, again I think we are taking a pretty measured approach towards our non-agency exposure. And again, it's really driven by -- if you continuously value, you would kind of see some increase in non-agency portfolio, if you don't then it would we kind of see the spreads tighten. I think you -- we probably will stay right here or decrease.

Mike Widner - KBW

And then, so one final one. I notice you guys took -- it would appear that you sold all your swaptions or some probably expired. But you do not appear to have any swaptions at all on the book right now which is quite a bit different than where you were in the past couple quarter. So just maybe if you could talk about that and how does that reflect, your view on where rates are or where rates might go?

Anup Agarwal

Yeah, I think great question. I think I will ask Bonnie Wongtrakool to respond to it.

Bonnie Wongtrakool

Right. So we did manage our swaps pretty actively through the quarter as the market moved and we ended up taking a lot some of our swaptions after the July payroll as we felt that the tell off was pretty much over and that we felt that rates will move back into a range and volatility would fall. So we moved our swaptions into swaps as we felt that that was a better way to head our portfolio.


Our next question comes from a line of Daniel Furtado with Jefferies. Please go ahead.

Daniel Furtado - Jefferies

Thank you. But my question was asked and answered.


Thank you. (Operator Instructions).

Our next question comes from the line of Steve DeLaney with JMP Securities. Please go ahead.

Steve DeLaney - JMP Securities

I would like to ask question, Mike touched on the non-agency allocation. I was just curious when you look at the agency market today, your portfolio is about 90% concentrated in spec pools mostly 30 year, and I was just curios if the September 30 portfolio reflects where you see the best relative value today as you're reinvesting your repayments?

Anup Agarwal

Yeah I mean -- look, I think we still find agency portfolio very attractive given the current economic outlook. And --

Steve DeLaney – JMP Securities

And I'm just trying to get within agency. Yeah, I heard you loud and clear that Agency is where you want to be versus non-Agency. But what so what I'm trying to get at is, within the stand box of the universe of the Agency universe, what would you like the best today? Thanks.

Bonnie Wongtrakool

And Steve this is Bonnie Wongtrakool. Yeah, we realize the composition of our portfolio right now. I would say that largely if you were to start from scratch today, the starting buy would be similar to what we have in there. It would be like 20 years, you know, 20 years looks great. I think they provide better value than 15 years, if you want to try and shorten up their duration -- their duration a little bit. We still like the MHA nondeliverable paper, which we have in the portfolio right now in loan and balanced support. These are the types of things we will buy if you're starting from scratch today and these are the types of things that are ready in the portfolio now.

Steve DeLaney – JMP Securities

This sounds like Bonnie there is still within -- Gavin and I know both commented on the interest rate, you being range bound. And it sounds like your view of -- is that you still need to be sensitive towards prepay protection and you were a little higher on the 10-year but you're definitely still worried about prepayment speed it tells me from the paper you own?

Bonnie Wongtrakool

And I think we definitely have a risking of staff a lot lower than their thoughts on the market, so we could see, deals go down again. I actually think our portfolio is positioned pretty well so that we have a lot of call protected securities in there. But to the point about extension, the story that I just mentioned also we have extension protection as well going down it's a different story there.

Steve DeLaney – JMP Securities


Bonnie Wongtrakool

Right. And then, MHA paper as we sell off we would expect that the turnover on those would be pretty good as the LTVs come down on the paper. I don't know if that answers your question.

Steve DeLaney – JMP Securities

And so, I mean just the way what I'm hearing from the team here is that there is no reason for us to expect that you've taken the big swings to reposition the portfolios since 9/30?

Bonnie Wongtrakool

That's fair.

Gavin James

Not at all.

Steve DeLaney – JMP Securities

Okay. Thank you for that. And then, lastly, just quickly. Adjusted leverage with the TBAs of non-TOMs, it does appear to be at the higher end of the range for the group and I'm just curious if -- I apologize if you addressed this earlier before I got on the call. But just curious if you look at the non-TOMs given where rates are today volatility is better, is that a level a leverage that you're -- you feel you would be comfortable with over the next couple of quarters?

Steve Sherwyn

I mean I think you would kind of see our leverage kind of very much range bound within the range of 6 to 10. I think where we have the current leverage. I think we're very comfortable with the current positioning of the portfolio.


(Operator instructions) We have no further questions Mr. James?

Gavin James

Thank you. Well, thanks everybody for joining us on the call and it looks we will be seeing many of you in the months ahead. And once again, many thanks for your time today. With that we will close the call.


Ladies and gentlemen, this concludes the Western Asset Mortgage Capital Corporation third quarter earnings conference call. You may now disconnect.

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