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CYS Investments, Inc. (NYSE:CYS)

Q2 2014 Earnings Conference Call

July 22, 2014 9:00 am ET

Executives

Richard E. Cleary - COO and Assistant Secretary

Kevin E. Grant - Chairman, President, CEO and CIO

Bill Shean - Managing Director

Analysts

Steven C. DeLaney - JMP Securities

Dan Altscher - FBR Capital Markets

Douglas Harter - Credit Suisse

Joel Houck - Wells Fargo

Michael R. Widner - Keefe, Bruyette & Woods

Aaron Saganovich - Evercore

Kevin Casey - Casey Capital

Jason Stewart - Compass Point

Operator

Good morning and welcome to the CYS Investments Incorporated 2014 Second Quarter Earnings Conference Call. During management's presentation, your line will be in a listen-only mode. At the conclusion of management's remarks, there will be a question-and-answer session. I will provide you with instructions to enter the Q&A queue after management's comments.

For opening remarks and introductions, I will now turn the call over to Rick Cleary, CYS' Chief Operating Officer. Please go ahead, Mr. Cleary.

Richard E. Cleary

Thank you. Good morning and welcome to CYS 2014 second quarter earnings conference call. Today's call is being recorded and access to the recording of the call will be available on the Company's Web-site at www.cysinv.com beginning at 3 PM Eastern Time this afternoon.

Please be advised that certain information presented and certain statements made during this morning's presentation with respect to future financial or business performance, strategies or expectations may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements indicate or are based on management's beliefs, assumptions and expectations of the CYS' future performance taking into account information currently in the Company's possession.

Beliefs, assumptions and expectations are subject to change, risk and uncertainty as a result of possible events or factors, not all of which are known to management or within management's control. If management's underlying beliefs, assumptions and expectations prove incorrect or change, then the Company's performance and its business, financial condition, liquidity and results of operation may vary materially from those expressed, anticipated or contemplated in any of their forward-looking statements. In any event, actual results may differ.

You are invited to refer to the forward-looking statement disclaimer contained in the Company's annual report on Form 10-K and quarterly reports on Form 10-Q filed with the SEC, which provide a description of some of the factors that could have a material impact on the Company's performance and could cause actual results to differ from those that may be expressed in forward-looking statements.

Also, please note that the content of this conference call contains time-sensitive information that is accurate only as of today, Tuesday, July 22, 2014. The Company does not intend to and undertakes no duty to update the information to reflect future events or circumstances. To better understand our results, it'd be helpful to have available the press release that we issued last night. As in past releases, the earnings release includes information regarding non-GAAP financial measures including reconciliation of those measures to GAAP measures, which may be discussed on the call.

I'd now like to turn the call over to our CEO, Kevin Grant.

Kevin E. Grant

Thank you, Rick. Good morning and welcome to our 2014 second quarter earnings conference call. As usual, joining Rick and me this morning is our CFO, Frances Spark, and Bill Shean from the investment team. First a few comments and then we look forward to your questions.

We posted another solid quarter. Our book value moved up and we delivered another $0.32 dividend. Most importantly, we added to our hedges, reducing our duration gap substantially. We added six new swaps with seven year and five year terms. These replaced and extended some older swaps and caps that had rolled down the curve so much that they're really not doing us much good going forward.

We also added five new lenders and are in active negotiations with more. There is a lot of cash in the world and it is simply a matter of finding intermediaries to connect the suppliers of cash with the suppliers of government bond collateral like CYS.

On the asset side, both Agency mortgage securities and treasuries continue to rally through the second quarter of 2014. At this point, it looks like the bond market has retraced about one third of the rising rates that we experienced in 2013. By historical standards, that's a pretty typical retracement after a big move like we had last year. We see this and saw this as an opportunity to add to our hedges.

While it seems and feels like we're in a period of stability, there are substantial crosscurrents over the horizon. Some market participants see the Fed pulling up their forward rate guidance, others see that forward rate guidance being pushed out. This all averages out to a consensus for a mid 2015 first tightening. We recognize both views but the endpoint for this next tightening cycle is now really what matters most.

The Fed's Dot Chart in the FOMC's June release shows a fairly tight average of 1% to 1.25% for year-end 2015 and about 2.5% for year-end 2016. With the 10 year U.S. Treasury around 2.5%, the bond market suggests this amount of tightening at that pace is too aggressive for the economic environment, and in such a tightening with producer recession in 2016-2017. Regardless of how this actually plays out, we took the opportunity in Q2 to extend our hedges and reduce our interest rate exposures to the growing uncertainty.

99% of our repo borrowings are now covered by a hedge and these hedges are longer in tenure. At this point now that there is at least a little visibility around when LIBOR might actually start to move up, we prefer simple interest rate swaps since on simple interest rate swaps we receive LIBOR on the floating rate side of the swap. This should provide a very well correlated offset to our repo borrowing rates.

The drop in gross mortgage supply which we've been talking about for many quarters, coupled with the Fed's appetite over the past many months, has kept mortgage securities prices firm. We have not seen a meaningful pickup in mortgage supply like we normally do in the summer. This seems to be partly driven by the backup in rates last year combined with a very tight credit box as defined by the rules around QM. The trail off in supply has closely matched the Fed's taper, so the mortgage securities market has not experienced any big disruptions.

Looking forward, the current stable environment is good for our business. There have been few surprises either on the inflation front or employment front that have been sufficient to cause the Fed to change their guidance. The impacts of demographics, technology replacing labor and the tight regulatory environment for banks and mortgage lending are still in place and unlikely to reverse anytime soon. This continues to suggest to us fairly stable earnings and dividend power for the near term.

At this point, we're happy to take your questions. I'll turn it over to Paula. It'll take Paula a moment to assemble a queue. Paula?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Steve DeLaney from JMP Securities. Please go ahead.

Steven C. DeLaney - JMP Securities

Kevin, I'd like to maybe start and talk a little bit more about the repo market conditions. I was thinking back when I saw your release last night, you mentioned you've been adding counterparties. I think it was about a year ago, July of last year, that the Fed Reserve initially introduced this concept of a supplemental leverage ratio of 6% on assets for the larger banks. And just curious as you have talked with your counterparties and observed that market over the last year, other than Deutsche Bank which I think is pretty well publicised and that pullback began before the SLR, have you guys noticed any large global banks backing away from the repo market in the last year?

Kevin E. Grant

For us the answer is, no, which may sound surprising. What we've noticed is, in general the bigger banks are suggesting to us that they are taking down their gross leverage but government bonds are favorable collateral. So for us, we're not feeling that pressure. However from a management perspective, we're prepared for it and this is why we continue to add repo counterparties. And it really, Steve, there's so much cash in the world, what this is actually doing is it's creating an opportunity for other lenders to basically get into the repo business or amp up the repo business because it's such a good business and the bigger banks are basically pressured to reduce their exposure to it.

Steven C. DeLaney - JMP Securities

That's helpful, leads into the second part of my question. Post crisis – I mean pre-crisis I always remember kind of thinking about three dozen repo lenders, you know 35, something like that, and then I think during the crisis and afterwards we might have shrunk back to, most people had 25 to 30. Well now, you're up to 43 and sounding like you're adding more. Could you just generally describe these newer entrants that we're seeing into the market, kind of what do those companies look like and are they going to be able to operate in a different regulatory capital regime than these large banks, is that one reason that they're stepping in here?

Kevin E. Grant

If you slice off the top, I don't know, dozen global banks, there are whole host of other still very large banks that are relative to the big banks pretty under-levered and have capacity for it. So the repo counterparties we're adding are kind-of of that character. Very, very few small, I mean kind of boutique shops, are on that list. These are substantial institutions. So it's just institutions that haven't really focused on government repo historically because the market share hasn't been available to them and now the market share is available to them because the big banks are under pressure.

Steven C. DeLaney - JMP Securities

Got it. Okay, that's helpful. And just lastly, I'm sure someone will be asking you about leverage in the portfolio, but tied into repo, just given your dry powder positioning, if you were to see a cheapening of mortgages say over the next six months or so and decide to pull the trigger, do you have any concerns that if you were to take leverage up a turn that you would have any problem finding an incremental 2 billion of repo available to CYS?

Kevin E. Grant

No, I have no concerns about that at all. I'm quite certain we could go to whatever level of leverage we needed.

Steven C. DeLaney - JMP Securities

Great. Thanks for the comments and congratulations on a really nice quarter.

Operator

Our next question comes from Dan Altscher from FBR Capital Markets. Please go ahead.

Dan Altscher - FBR Capital Markets

My first question is on the new share buyback, I guess the upped share buyback reauthorization. Is there an appetite right now to be using that with the stock trading south of 90% of book value or is that just there to maybe increase some flexibility if we get some pullback as taper trails off?

Kevin E. Grant

We haven't touched it in almost two years and we haven't done any buybacks past couple of quarters just because it's timing and windows and all that, but we think having the additional capacity and flexibility going into this period that we think is going to be noisier, just it's convenient to have it in basically ready to go. So it was kind of time to refresh the capacity and the Board was very onboard with that idea.

Dan Altscher - FBR Capital Markets

Got it, okay. And Kevin, you've I think expressed some maybe relative concern about some cheapening in MBS as we I guess approach October and November and taper is done. Is the portfolio generally allocated right now to or positioned appropriately for that? In other words, are you basically set up right now for that October, November time frame or is there maybe some work to be done, whether it's on the asset side or the hedge side?

Kevin E. Grant

I think we're in pretty good shape. We're about as set up forward as you can be. The tension here is actually pretty remarkable and it's kind of creating a little bit of a mirage I think for the Fed to interpret what's going on. The supply picture is really low, I mean very, very low. We've never seen the supply of mortgages this low in my rather lengthy career. But the Fed has been taking out so much supply and that obviously is going to stop this fall.

So the question then is, what's the balance? And it feels to us like if there's a cheapening it won't be that significant but there is likely to be a cheapening, and I would just observe there are a lot of people that are invested in the mortgage securities market right now that just it's not their home base and they are in the mortgage securities market basically for the advantage of the dollar rolls with no desire to take delivery of securities and it's just not their home place.

And when the dollar rolls disappear and get back to normal levels, just fair value, or maybe slightly special, I think a lot of those folks will disappear from our market. And we just – it's very hard to gauge what kind of opportunity that will create for us. If we were extraordinarily bearish on the mortgage market, you'd see our leverage lower, but we're not. We think we're about the right compromise right here.

Dan Altscher - FBR Capital Markets

Okay, thanks, that's helpful. And then just a follow-up question. In the press release, it's mentioned the CPR in July, looks like it's picking up north of 10%, maybe about 11%. I guess we kind of have steady pickup generally in CPRs through the spring and now I guess into July. Can you maybe just help triangulate why or what you're seeing in terms of making or helping CPRs pickup, yet overall slow supply of new Agency MBS is still very low though?

Kevin E. Grant

This is a normal seasonal. There's the spring buying season which was very much a non-event this year but it's still there, creates some turnover and those prepayments come through in June, July, August. So there's some of that. There's also a natural seasoning of the portfolio as it gets a little older and kind of picks up. I would say the July number is still well below what is historical norm. Would you agree, Bill?

Bill Shean

Right. The only thing I'd add is we also had a couple of pulls that had increases, significant increases. So you could see our number actually drop. We don't know that but we could actually see it drop next time, who knows.

Dan Altscher - FBR Capital Markets

Got it, .okay. So maybe just some seasonality and some remnant from the spring season, just following through this next month or so?

Kevin E. Grant

Exactly.

Dan Altscher - FBR Capital Markets

Got it. Thanks so much.

Operator

Our next question comes from Douglas Harter from Credit Suisse. Please go ahead.

Douglas Harter - Credit Suisse

Kevin, I was hoping you could talk a little bit about what conditions you saw change that caused you to rotate about 1 billion of treasuries into slightly more than that of MBS so far in the third quarter?

Kevin E. Grant

It's very minor in nature. When the calendar turned into July, we noticed in the dollar roll market, we were able to actually roll a bunch of bonds early, so we took advantage, but we noticed in the dollar roll market that some of the extreme specialness was not there and that caused a very slight cheapening in mortgages, probably a blip to most people that are looking at it, and we're just taking this as a sign that there are cash bonds available, which it turns out there are, not a whole lot of them but there are, and so that was the reason, nothing more complicated than that.

Douglas Harter - Credit Suisse

Great. And then, looking at the average yields you had in your various buckets, they seem to all have declined quarter over quarter. Was there significant portfolio rebalancing that went on during the second quarter that led to that decline or is that more kind of an assumption of what the prepays are going to be?

Kevin E. Grant

Remember we don't project prepayments to come up with yield number. So yield number is an actual experienced number. But don't forget prices were up, so yields were down. It's kind of that's just the way the calculation works.

Douglas Harter - Credit Suisse

Got it. So that yield is based on the market price as opposed to your cost basis?

Kevin E. Grant

Right.

Douglas Harter - Credit Suisse

Got it. Thank you.

Operator

Our next question comes from Joel Houck from Wells Fargo. Please go ahead.

Joel Houck - Wells Fargo

I guess a little more color or granularity on the marginal return you're seeing versus what you're replacing, particularly in light of the fact that you sold quite a bit of treasury position and redeployed back into the 30 year agency?

Kevin E. Grant

We happen to like the 30 year premium market, premium market in particular, not that there are high premiums available, but maybe Bill could run through the investments that's available today.

Bill Shean

Sure. If you're thinking about for our portfolio, we've particularly, as Kevin said, we've been purchasing some premium 30 years and those yields are roughly 3.25-ish right now versus a rough yield of anywhere between 1 and 1.50 on a treasury. And then in the 15 year market, you've got about a 2.50 yield. So as you move, roll back out of treasuries into mortgages, there's a substantial pickup in yield for the portfolio.

Joel Houck - Wells Fargo

Okay. And I guess switching gears on the leverage, that kind of has remained constant and I guess on a longer historical basis relatively low. Is this a case where once we kind of get to the finish line of the taper, that we might, you guys might be more amenable to moving that up or is this kind of the new CYS model where you can still generate relatively attractive returns but not take so much financial risk in terms of leverage?

Kevin E. Grant

Yes, strategically this is kind of the same story I've expressed over the past couple of quarters. This is more of a tactical thing. The Fed is – this will be an experience where the Fed, the U.S. Fed is backing away from quantitative easing. This is there is no case study elsewhere in the world to point to, to say this is what's going to happen. And that suggest to us that this is a period of time where you just simply need to be more conservative, have more liquidity, less leverage, and we could just sail right through this thing, no problem, but that just seems unlikely to us and suggest that there's probably going to be some better opportunities as we work our way through this. I don't know whether those opportunities will happen at the end of taper or around the time of the first tightening or around the time of the first messaging of the first tightening, it just feels to us like that's kind of the next 6 to 12 months.

Joel Houck - Wells Fargo

Okay. And again, nice growth in book value in the quarter. I missed the earlier comments. Did you provide any kind of inter-quarter color so far in Q3 on the book value?

Kevin E. Grant

We have not, but Bill, how's the bond market been since into June?

Bill Shean

We have had a little bit of a sell-off. So the market is down about 0.25 point to 12.375% depending on the particular bond. So it's a little bit of a sell-off since June 30.

Joel Houck - Wells Fargo

Okay, nice job staying through this tough environment, guys. Thanks very much.

Operator

(Operator Instructions) Our next question comes from Mike Widner from KBW. Please go ahead.

Michael R. Widner - Keefe, Bruyette & Woods

Just had a couple of quick follow-ups. First, Bill, I think you said with regard to prepayments that things might move, could possibly move slightly lower. Just wondering if you were saying that in reference to the July 10.8 number or to the overall Q2 number of 7.6?

Bill Shean

The refi index, Mike, is down a little bit from month end, and we've also got the seasonal. So I would say the whole mortgage market as we come into the fourth quarter seasonally slows almost every year. So we wouldn't expect without a big rate movement down that to change. So we'd expect the whole numbers to – the numbers to be declining slightly.

Michael R. Widner - Keefe, Bruyette & Woods

So even relative to the 7.6 that you posted for the quarter?

Kevin E. Grant

I mean it's so hard to predict, Mike.

Michael R. Widner - Keefe, Bruyette & Woods

No I understand, it's just a big difference between…

Kevin E. Grant

[It's been] (ph) so low relative to anything we've seen in the history. It's pretty tough to nail it down.

Bill Shean

Splitting the hairs between 8 and 10 is pretty tricky.

Michael R. Widner - Keefe, Bruyette & Woods

No, I mean it was a 10.8 number that you posted for July and that's 320 basis points between the 7.6 and the 10.8, so I was just surprised.

Kevin E. Grant

Yes, but Mike, back on the day we were talking about 36 versus…

Michael R. Widner - Keefe, Bruyette & Woods

I hear you.

Kevin E. Grant

So come on.

Michael R. Widner - Keefe, Bruyette & Woods

I want a precise number, guys, but okay, thanks. So I guess my second question, again follow-up, you talked about selling some of the treasuries, about 1 billion of treasuries and buying 1.4 billion of MBS subsequent to the quarter. Were there any adjustments to the hedge book or should we expect any adjustments to the hedge book to go along with that or did you kind of make the hedges before you made the swap, if you will?

Kevin E. Grant

We are working on the whole notion of reducing our duration gap and continuing to reduce our duration gap, and we're going to do – we've executed this in a very disciplined non-panic way and it's worked for us beautifully. So we'd like to get that duration gap even further down. In the supplemental deck that comes out later, you'll see some detail around this, but that's really the goal. And this gets to this idea that when the Fed actually starts to tighten and move short rates, then the hedges will do what they're supposed to do. The mark to market on the hedges is really the tricky part. The cash flow is the cash flow. The hedges pay us LIBOR and when LIBOR starts to go up, that floating rate leg of the hedge becomes very valuable as an offset to our repo borrowing cost. So, we're moving to a place where the duration gap is lower than it's been historically and we're using more just generic swaps for that floating rate alike.

Michael R. Widner - Keefe, Bruyette & Woods

So what I would infer from that then is that at some point during the quarter we should probably expect some additional swaps to come on given that you've already sort of added some MBS, is that…?

Kevin E. Grant

Yes, it's going to be market dependent, Mike, but don't be surprised by that.

Michael R. Widner - Keefe, Bruyette & Woods

So just one other question. We've seen some of the other mortgage REITs moving and using more Eurodollar futures just part because of less capital required for those versus swaps, but your point about cash flows, I mean the cash flow characteristics are reasonably different than swaps. So I mean have you guys thought about and how do you view sort of the Eurodollar futures relative to swaps going forward?

Kevin E. Grant

We were very early adopting the CME and all the derivatives clearing stuff and we were very early in the queue and the pipeline. So we moved everything over to the CME very early in the process around the Dodd-Frank stuff. So we're completely content. The swaps are very convenient, the floating rate leg works, it just works beautifully for this business, it's the best fit, and we adopted all the stuff early. So we're happy where we are. We've spent plenty of time looking at Eurodollar futures and we really don't see the advantage. Keep in mind that our liquidity at quarter end was 76%. So we don't really have a liquidity issue.

Michael R. Widner - Keefe, Bruyette & Woods

And I mean certainly a big part of that is the lower leverage, so I mean obviously it all ties together, but if you were to head back to nine times for example that…

Kevin E. Grant

The big reason that the liquidity is so high, yes, it's the lower leverage, but the big reason is, we just own government securities. So our haircuts are generally 5%, and since we don't have any credit assets, we don't have to post just huge amounts of collateral against those borrows.

Michael R. Widner - Keefe, Bruyette & Woods

Right. Thanks as always and nice quarter, guys.

Operator

Our next question comes from Aaron Saganovich from Evercore. Please go ahead.

Aaron Saganovich - Evercore

You mentioned I believe something about the dollar roll becoming I guess a little less attractive recently and helped cause the blip where you took advantage of the 30 year. How long do you think the dollar roll will remain I guess special as it has been, it is going to wait until after the Fed stops its purchases or is the supply so type that that may remain special for a while?

Bill Shean

Aaron, we certainly think there's – it will continue for a while. Having the Fed buying many less bonds and terminating their program in October we think will certainly lower them. But for the time being, we think they are special and continue to be somewhat special, just not as special as their height a few months ago when we really peaked out when all the forces were working positively for them.

Aaron Saganovich - Evercore

And how do you think that will affect your dollar roll income? I know you've always historically made forward purchases to lower the cost, but would that significantly reduce the dollar roll income that you have?

Kevin E. Grant

It's really driven by how much we choose to allocate to that particular strategy, and if it's a wash, if it's just arbitrage free, then we preferred our own cash bonds. So it again is very dependent on market conditions.

Aaron Saganovich - Evercore

Great, that makes sense. And then lastly, you talked about the yield benefits of moving from treasury to the MBS. What about on the cost side I guess if we're going to look at the net spread benefit of rolling from I would assume cheaper to finance treasury investments versus your MBS?

Kevin E. Grant

I'll let Bill comment about the financing rates in the treasury market which are still very good, but the thing about the treasuries, the thing that really pushed us over the edge to buy the treasuries in the first place was the roll down, and as the curve steep, a five-year treasury as an example rolls down the curve and in a year it becomes a four-year which is naturally lower on the curve, so it produces some capital gain, and that actually worked beautifully over the period of time that we own them.

However, at this point, our confidence around Fed funds being at zero a year from now is vastly diminished. So the roll-down story – I don't think you can really hang your head on over us let's say a one-year horizon. So that kind of reduced kind of the additional benefit of this. But I'll let Bill talk about the financing.

Bill Shean

Right. You make a good point. The treasury financing, the special, let's say the current five-year is financing at about minus 50 basis points, and then general collateral is around 12 to 15 basis points let's say versus our mortgage repo is running in the low 30s. So there is a give there which was another reason why combined with that roll-down we thought it was very powerful, but as Kevin said, the roll-down there is less likely going forward, so we thought we'd move out some treasuries and move into some mortgages.

Aaron Saganovich - Evercore

Okay, thank you.

Operator

Our next question comes from Kevin Casey from Casey Capital. Please go ahead.

Kevin Casey - Casey Capital

Mike actually kind of asked my question about the portfolio positioning, but my follow-up is, it sounds like you are basically just going to take advantage of the volatility, i.e., put swaps on in Q2 and then put the other trade on in Q3. Is that kind of what your game plan is, and also, is that kind of what happened?

Kevin E. Grant

That's what's happened in the past and we try to be opportunistic to the extent that we can. The volatility in the bond market has been recently very low. So we'd love to be able to say we'll be able to execute that idea going forward but we need some volatility to make that happen which just right now just doesn't appear like a near-term thing.

Kevin Casey - Casey Capital

Okay thanks.

Operator

(Operator Instructions) Our next question comes from Jason Stewart from Compass Point. Please go ahead.

Jason Stewart - Compass Point

Kevin, how short would you be willing to take the expiration, time to expiration on the caps portfolio?

Kevin E. Grant

Not sure exactly what you mean. The caps that we have left in the portfolio have pretty low strikes and the thing about caps is that they don't cash flow until LIBOR gets to that strike level, and then of course they pay us the difference between LIBOR and whatever that strike level is. So I think most of the caps are around 1.25 and they are pretty long dated. So we look at them and it's really a judgment. They look like there's a real chance for them to cash flow and they would move up in market value if the probability of those cash flows got higher, and they are long enough in tenure remaining that we think that we'll keep them for a while. So, I think the question was, if you have a two year cap and it struck at 1.5, it's probably not going to cash flow for us, it's probably not doing any good, and those are the kinds of caps that we get rid of.

Jason Stewart - Compass Point

I mean the gist of the question, you took the strike down to 1.20 versus 1.40 but the tenure went up to 5.6 versus 5.1 and just trying to gauge your sensitivity for cash flow between the strike and the tenure of the portfolio, so it weighted – it seems like you're more sensitive to the strike rather than the tenure.

Kevin E. Grant

It's a combination of both, right, because it's the pacing of the movement of LIBOR. If LIBOR goes up rapidly, our short cap would do wonders, but we don't see that happening.

Jason Stewart - Compass Point

Okay, that's helpful, thanks. And then just remind me, the CPR number you quote, that does not include non-settled bonds or does not include the TBA or dollar rolls, right?

Kevin E. Grant

Right.

Jason Stewart - Compass Point

Okay, thanks.

Operator

I will now turn the call back to Mr. Cleary for closing comments.

Richard E. Cleary

Thanks, Paula, and on behalf of Kevin, Frances, Bill, and the entire CYS management team, I'd like to thank you for taking the time to participate and speak with us this morning. Thank you for your continued support and interest and have a nice day.

Operator

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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