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Why the bailout is a bad idea (update)
Posted by: McQ on Thursday, September 25, 2008

The bailout deals with failing financial institutions. But what is it the bailout will be buying?

Mortgages backed securities. Bad mortgage backed securities (MBS).

So what are they worth?

Who the heck knows? Has the housing market bottomed out yet so we can get some idea of their worth?

No.

If that's the case, how do they know what the MBS they're going to buy are worth?

They don't know.

Then there's the law of unintended consequences which could very well come into play. What if the bailout deepens the financial crisis. That's a very distinct possibility as Peter Orszag (Director of CBO) pointed out yesterday.
"Ironically, the intervention could even trigger additional failures of large institutions, because some institutions may be carrying troubled assets on their books at inflated values," Orszag said in his testimony. "Establishing clearer prices might reveal those institutions to be insolvent."

In an interview later yesterday, Orszag explained using the following example: Suppose a company has Asset X, whose value is recorded on the books as $100. Because of the current economic decline, Asset X's real value has dropped to $50. If the company takes part in the government bailout and sells Asset X for $50, the company has to report a $50 loss on its books. On a scale of millions of dollars, such write-downs could ruin a company.

Such companies "look solvent today only because it's kind of hidden," Orszag said. "They actually are insolvent" already, he said.
Oszag asks the same questions:
"The key question is: What are we buying and what are we paying for it?"
The answer - no one knows. But what we do know is that the bailout will establish some sort of price and that price could cause other financial institutions see an instant devaluation of some of their assets to the point that they become insolvent.

As I see it, the proposed $700 billion will end up being a down payment on a very expensive purchase with little or no return.

There is no easy way out of this mess, and I certainly don't see government intervention as something that will stem the tide. If government wants to do anything it should do things to create an incentive to invest - cut taxes on corporations, capital gains, etc (some of the ideas Newt Gingrich is pushing). But the military guy in me thinks that reinforcing failure isn't going to save the day, and in fact may end up making it even worse.

UPDATE: Arnold Kling on the bailout:
But an issue about which they know less than I do is mortgage credit risk. To them, the problem of pricing mortgage assets is a detail to be worked out later, as when Ludwig sniffs that he is sure that "the plumbing can be taken care of." Well, I'm a plumber, and I don't think so. Based on my knowledge of pricing mortgage credit risk, I believe that the bailout proposal is far riskier than other alternatives.

How did we get into this mess in the first place? We got here because financial executives took on mortgage credit risk without understanding what they were doing. Some of them were new to the business, like the high-flying Wall Street firms who entered the industry during the boom. Some of them thought they were insulated from risk, because of new derivative hedging instruments. Some of the executives never belonged in the business in the first place, including Dick Syron at Freddie Mac, who in 2003 took over a firm where there was lots of knowledge of mortgage credit risk and proceeded to flout the warnings of experienced middle managers and the Chief Risk Officer about the firm's plunge into subprime lending. Congressional and Administration meddling in support of "affordable housing" played a role, and those folks are still around working on the latest legislation.

I am wearing two hats in opposition to the bailout idea. One hat is my libertarian hat, which does not like the power grab. The other hat is the applied financial economics hat, which was my career in the late 1980's and early 1990's. Speaking from the latter point of view, I have to warn that nobody involved in the bailout proposal has sufficient knowledge of mortgage credit risk. They are like Dick Syron—in over their heads without realizing it. The last thing we need in the mortgage market is another large, inexperienced player.

You can say that after the bill is enacted, the big boys will hire technical economists to deal with the plumbing. But that will be too late. Technical economists will not be able to fix a concept that has such poor risk-reward trade-offs built into it.
 
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In response....
http://biglizards.net/blog/archives/2008/09/democrats_try_t_1.html

Which provides an answer to how the securities will be valued and why the "bail out" is necessary. Some regulatory/legislation is necessary, according to Big lizard, as the securities cannot be held by some entities currently holding them, but cannot be sold because they are non-valued-not the same thing as worthless, merely not valued, an indefinite quantity. So, they have to be sold and yet cannot be, so something must be done, to value them or to allow their retention by certain groups.
 
Written By: Joe
URL: http://
What’s not going to be discussed is all the earmarks that will be attached to the bill, help for this group and that group, free money for this one and that one. Question: Who is hurt by allowing Judges to reset loans? Answer: All those who we financially prudent.

Take a minute and think about that.... Your neighbor who is over extended goes to the court, gets his loan reset and the value of your house goes down and the bank loses more money!
 
Written By: Commander Tom
URL: http://
A very clear article on why the bailout is probably not needed, and if needed, probably shouldn’t be as big as it’s being inflated.

It’s interesting to me that a lot of people who’ve lived through previous economic crisis, such as the S&L collapse are describing the current situation as less severe.

There are 2 things I’ve heard in the last day or so, that ought to be considered.

1 - put the unwanted liabilities for sale on the open market. If nobody picks them up, the government buys at a discount.

2 - "mark to market" ought to be rescinded.

RTWT

http://article.nationalreview.com/?q=ZDNkOTc5ZTY4YTlkMDkyMDY3MmI1NTk5ZjZmZDkxY2U=
To arrive at a principled view on this intervention, we must answer three critical questions: Is it necessary? Will it work? And even then, is it morally justifiable?

...

It also seems at first blush that the government ought to not bail out banks that made terrible investments they now regret. But remember, many of these bad investments were the result of government meddling. Would we be experiencing a sharp housing downturn, and a wave of mortgage defaults, if the Federal Reserve had not created a housing bubble and a mortgage bubble in the first place by artificially lowering interest rates to 1 percent in 2003 and 2004? And how much was the housing bubble inflated by the highly leveraged mortgage buying spree of government-sponsored and government-influenced Fannie Mae and Freddie Mac? Shouldn’t the government shoulder some responsibility for its own mistakes?
 
Written By: Keith_Indy
URL: http://asecondhandconjecture.com
What W’s speech should have been:

"My fellow Americans. As you well know, a massive act of fraud has been committed upon the American people. Last night, the Justice Department summoned Grand Juries across several states and indicted many officials in the companies in question, as well as many officials in the banking system. As my role as the nation’s chief law enforcement officer, I am now summoning more than 400 Federal marshals to arrest those responsible for this fraud. Lawbreaking must not be tolerated in a free society. Thank you and God Bless America."
 
Written By: Dubya
URL: http://
The argument for the bailout, as I understand it, is that without the bailout banks will likely stop issuing credit. Since many buisnesses depend upon credit for their day to day operation, this will seriously damage buisnesses, and possibly push us towards depression.

Granted it isn’t a free market solution, but this isn’t a free market problem, either.
 
Written By: Don
URL: http://
It’s interesting to me that a lot of people who’ve lived through previous economic crisis, such as the S&L collapse are describing the current situation as less severe.
I think that’s exactly right. There have been much worse times for banks in our nation’s history.

 
Written By: Arcs
URL: http://
Bravo McQ. I asked the same question on another blog this a.m. What happens if the financial markets melt down after the bailout? What then? So far, I haven’t seen any speculation on that scenario. It must be unthinkable.
 
Written By: feeblemind
URL: http://
How did we function before Mortgage backed securities? And why do we need them now?

Seems to me our economy has shifted from something that used to be less economically fragile to something akin to a house of cards.
 
Written By: jpm100
URL: http://
To add, it seems like this fix being paid back is based on the assumption that the economy will go up and those 700 billion will be worth something.

That’s the same assumption that made people look the other way that got us into this mess. It counts on the economy getting better. Which means if the economy goes the wrong way, its a positive feedback.
 
Written By: jpm100
URL: http://
If we don’t pump some "bankable" money into the system, banks will contract the money supply, just as they are supposed to do.

Mortgage-backed securities used to be bankable but the GSEs started pumping out so much trash as is now clear from the bursting real estate bubble that they are now useless as basis for the money supply.

There is no perfect solution. Someone is going to get screwed and someone will be enriched. Kind of like war - some guys get a bullet in the balls and some get medals they didn’t deserve.

Let the Bush Administration govern and get on with it.

A collapsed money supply was the main cause of the Great Depression according to Milton Friedman and supported by Amity Schales.

Imagine a world where everyone had to pay cash for a home, a car, a tractor, a new power plant.
 
Written By: Joseph Somsel
URL: http://
The easy solution is to just let the market work it all out. There is always a clearing price for every asset. You may not like that price and you may want to hold out for a better one. So it goes. What’s the big deal?
 
Written By: TheOldMan
URL: http://
The easy solution is to just let the market work it all out. There is always a clearing price for every asset. You may not like that price and you may want to hold out for a better one. So it goes. What’s the big deal?

Again because these assets are NOT valued, and Federal Law mandates that they be valued, SOX....and some entities MAY not hold indefinably valued securities, and so they are caught between HAVING to sell them and not be able to sell them, except at a tremendous discount....

As to those opposed to the "Bail out" here’s a question, we keep being told by libertarians that the Great Depression was the government’s fault because it failed to provide liquidity, so now when it’s time for government to not make that mistake, you guys don’t want it to...so fundamentally the complaint is just a way of knocking government, wrong in ’29-30, wrong today, not really learning any lessons from economic history, right?

 
Written By: Joe
URL: http://
"The answer - no one knows."

So it is possible that these mortgage backed securities are actually worth more than everybody thinks. I tend to think so, even as cynical as I am. After all, they are backed by real property, as opposed to intangibles like ’good will’ to which people are perfectly willing to assign great value. It could be that this is much ado about not that much.


"How did we function before Mortgage backed securities?"

Surely the financial wizards can figure out how to issue some credit to worthy borrowers. It is not like they have not created something out of nothing before, which is what credit is; a promise. Perhaps once they get over their panic induced paralysis someone will ask the same question. Anybody ever hear of a ’banker’s acceptance’?

Did anyone actually listen to Bush’s little talk? It seems the blame lies with those nasy little foreigners who flooded our markets with cash, causing credit to be overextended. We just couldn’t help ourselves.

 
Written By: timactual
URL: http://
" except at a tremendous discount"

TS.
 
Written By: timactual
URL: http://
Someone I always turn to when I can’t think clearly about a subject, and gov/economics is one area...

http://www.creators.com/opinion/john-stossel.html
The government-backed Fannie Mae and Freddie Mac were created precisely to interfere with the housing and mortgage markets. In effect, Freddie and Fannie diverted money to people who wouldn’t have qualified for mortgages in a real private market.

Had actual private companies performed these activities, they would have been subject to market checks. But they were not. The results were predictable.

Now that it’s all tumbling down, the politicians and pundits blame the free market.

It’s not simply misunderstanding. It’s demagoguery by people who will never admit that their "progressive" social policies have spawned a taxpayer bill that boggles the mind.

This is a story not of private enterprise but of cynical political opportunism. Moral hazard — the poisonous mix of private profits and taxpayer-covered losses — is what you get when politicians indulge their hubris to redesign society. The bailout of those companies holding bad mortgages — big-business soc!alism — sets us up for the next crisis.

...

Crisis is the friend of the State. The politicians are desperate to be seen as "showing leadership," so we’re surely in for a new round of government interventions. Watch for the equivalent of the Sarbanes-Oxley Act (http://tinyurl.com/3oeqex). There’ll be much posturing about how the new regulations "will keep this from ever happening again," but that’s more nonsense because the root problem is not lack of regulation. It’s government social engineering of the housing market, which will be unchanged.

This is the path to stagnation and poverty. As Nobel Laureate F.A. Hayek (http://tinyurl.com/dnuye) taught, markets are too complicated for planners to know enough to plan them. The relevant information, scattered unspoken among billions of market participants, is beyond the bureaucrats’ reach.

We do need protection from reckless businessmen. But there is only one way to provide that: market discipline. That means: no privileges, and no bailouts.
Got to love that soc!alism is a "bad" word for the filter...
 
Written By: Keith_Indy
URL: http://asecondhandconjecture.com
Free markets are essential (Free Markets, Free People and all that), except in America, where the Government can bail out companies with a gargantuan infusion of taxpayer money because we don’t really have free markets anyway. Got it. (repost)
 
Written By: David Shaughnessy
URL: http://
As to those opposed to the "Bail out" here’s a question, we keep being told by libertarians that the Great Depression was the government’s fault because it failed to provide liquidity, so now when it’s time for government to not make that mistake, you guys don’t want it to...so fundamentally the complaint is just a way of knocking government, wrong in ’29-30, wrong today, not really learning any lessons from economic history, right?
Not only did the government fail to provide or ensure liquidity during The Previously-Great Depression, Hoover signed the country’s largest tax increase to-date into law in 1932.

I’m against the bailout because it doesn’t pass the smell test for all the reasons listed in McQ’s post.
 
Written By: Arcs
URL: http://
http://www.creators.com/opinion/steve-chapman.html
If banks really need to get rid of this junk paper, they could have unloaded it before now. Merrill Lynch did itself a lot of good by facing reality and taking 22 cents on the dollar. But other companies now have the far more enticing option of selling to the government at a premium.

The point of the plan, after all, is to shore up struggling firms by awarding them more for those assets than they could get anywhere else. As an analysis in The Washington Post put it, "the more effective the plan, the more expensive it will be."

Not only that, the more effective it is, the more damage it will do to the free market system. Saving companies from their bad gambles turns business into a game of "profits for me, losses for you," corroding the incentives that make capitalism so innovative and efficient.

And for what? Bernanke warns of a recession. But economic downturns are not to be avoided at all costs. And one good thing about recessions is that they end, usually in a matter of months. An intervention of this nature, by contrast, would have malignant consequences for decades to come.

A group of 122 economists, including at least two Nobel laureates, signed a letter this week summarizing the danger: "If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted."

Not to mention the risk of giving the executive branch powers that a Russian czar would envy. If this bailout goes through, the term "limited government" will have to be permanently retired.
 
Written By: Keith_Indy
URL: http://asecondhandconjecture.com
That means: no privileges, and no bailouts.
And if it Causes the Panic of 1819 or the Depression of 30-39 well that’s just the price we pay right?

Get back to me when and IF (big if I admit, when unemployment hits 10-11% and credit is next to impossible to come by, like when you need to finance a car or a major home repair...Cat issued bonds this week, according to Megan McCardle, they would not sell except at deep discount, even though Caterpillar has NOTHING to do with the Financial Sector, when investor money runs and hides, it runs and hides from EVERYONE...not just Lehman Brothers.

Mayhap THIS bail out is bad, mayhap ANY bail out is bad, but I would like for all those blithely discussing "market discipline" to discuss the ramifications of market discipline, even on those of us who did not get an ARM for a house we couldn’t afford or who aren’t Fannie Mae or Freddie Mac managers or investors. Because the market discipline can unemploy YOU not just an investment banker.

Again, the Fed’s "caused" or worsened the Depression by their poor actions, I’m pleased to see the same sorts who feel that Hoover and FDR blew it are now in favour of blowing it here, again by failing to act. I can hardly wait for your grandchildren to discuss how economic conservatives, by dragging their feet, worsened the Crash of ’08.
 
Written By: Joe
URL: http://
Someone I always turn to when I can’t think clearly about a subject, and gov/economics is one area...
Me too.
Stossel is often the guy I turn to make economic sense. Like the time I felt bereft about gasoline prices. Stossel made it all clear to me when he stated that buying gasoline was just like buying ice cream.
I asked people to compare the price of gas to bottled water or ice cream you can buy inside the gas station. Most people were sure the gas was more expensive. But they’re wrong.
If you took the average price of a bottle of water, a gallon would cost nearly $7. A gallon of Haagen Dazs ice cream would set you back nearly $30 — 15 times the price of gas.
I thought… He’s right!! I do buy 30 gallons of ice cream every time I go to the store. I depend on it. Like the 100+ gallons of gasoline I buy for my business every week, I couldn’t get by without buying 100+ gallons of ice cream. It’s a good thing those stores have massive underground tanks designed to hold and deliver such quantities of Butter Pecan or I’d be SOL. And much like my trucks, my guys just won’t work without ten gallons of Rocky Road everyday. Stossel is an economic genius.

When tax time comes and my accountant looks at me oddly as I try to claim an expense of $20,000 worth of Chunky Monkey, I just look at him and say one word… “Stossel”, and I throw my hands in the air like I just don’t care.

Yeah, baby!!!

And I couldn’t possibly understand regurgitated Hayek unless it came from that mustachioed mastermind.


 
Written By: PogueMahone
URL: http://
Here’s another simpleir solutions...

http://econlog.econlib.org/archives/2008/09/a_simpler_solut.html
That is why some people say that the solution is to get rid of mark-to-market accounting. Let the banks estimate the "intrinsic" values of their mortgage securities. These values are higher than market values, so that using this alternative accounting the banks’ balance sheets won’t looks so bad. That way, they can keep lending. My problem with that is that phony accounting has a history of keeping failed institutions in business, raising the cost of the subsequent cleanup.

My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2008, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don’t want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations.

As with changing accounting rules, lowering capital requirements ultimately exposes the government funds that insure banks to more risk. That is the flaw in the idea. However, there has to be some risk exposure to tax payers for any policy that encourages bank lending.
 
Written By: Keith_Indy
URL: http://asecondhandconjecture.com
I can hardly wait for your grandchildren to discuss how economic conservatives, by dragging their feet, worsened the Crash of ’08.
Right because days and hours is going to make that much of a difference.

We should just rush headlong into whatever the PTB want to foist on everyone as "THE FINAL SOLUTION" for the problem we are in. No debate, no questioning, just get in line and take your pill like a good little boy. They know better then us, so we should just trust them, their from the government after all.

I’ve been hearing people shout it’s "inconceivable" to let something "that big" to fail. Well, I and others have presented some differing opinions which do have some conception about what might happen, if we let market forces take over where government regulations have mucked up could have been a market correction.

Yes, more people would be unemployed, credit would be tighter. And, as presented elsewhere, the situation may not be quite the financial doomsday people are running their mouths off about. As I’ve said a few times in the past couple of years, people with good credit, and a good down payment will still be able to obtain a mortgage or loan, just like they always have. Same with companies. Banks are still going to be looking for prime loans to make.

People at the margins will, horror of horrors, have to pay CASH. Which means they will likely have to live without more than 1 cellphone, internet, cable, a brand new car, or going out to eat every night. Gee, people will have to make sacrifices during tough financial times.

Or we could just let it ride, and pass on yesterdays bad financial decisions to your grandkids.

Pogue - and where exactly was Stossel wrong in saying that, taking inflation into account, gas prices are not/were not "higher then ever before." What he said was objectively true. And what he said didn’t go any further then that.
 
Written By: Keith_Indy
URL: http://asecondhandconjecture.com
There’s a program that President Bush got Congress to pass in late summer 2007 called FHA Secure. As passed, it was horribly limited by Loan to Value restrictions (97%), when the problem is that most folks are actually upside down on adjustable loans.

I’ve been calling for the expansion of FHA Secure - eliminating Loan to Value as a criterion, but retaining Debt to Income and all other qualifications. The cost, a lot cheaper than the bailout, could be paid by levy on the lenders being relieved of their loans to pay for eventual losses.

This would have the effect of blunting the flooding of the housing market with thousands (millions nationwide) of people being forced into short sale and foreclosure. By tamping down on the flood of properties (supply) limited demand would not drop the price nearly so far, blunting the deflation of the market and making it likely far more people could manage to dig out successfully, many of them upon their own efforts. It wouldn’t solve the crisis completely, but it would definitely lessen the problem by at least a factor of two, perhaps as high as five - reducing the problem to something the market can handle with very minimal direct assistance to financial megacorporations who should have known better.

Cost to Benefit ratio: Much better than any contemplated bailout. And it even helps the folks who were mislead into debt they couldn’t handle by alleged professionals who failed in their fiduciary duty.
 
Written By: Dan Melson
URL: http://www.searchlightcrusade.net/
Pogue - and where exactly was Stossel wrong in saying that, taking inflation into account, gas prices are not/were not "higher then ever before." What he said was objectively true. And what he said didn’t go any further then that.
He’s not wrong in saying that, taking inflation into account, gas prices are not/were not "higher then ever before." The problem is that he did go further than that by comparing the price of gasoline to bottled water and ice cream. If he had just left it at “taking inflation into account”, one would have trouble quibbling with him. But he didn’t, did he? He disingenuously tried to prove that gasoline was cheap by comparing it to bottled water and ice cream.

Whenever anyone of us buys gasoline, we buy it in bulk because we have to. The infrastructure and market is designed to sell it to us in bulk. If you disagree with that, then you should ask yourself when was the last time you bought 30 gallons of anything other than gasoline. Milk? No. Soda? No. Pancake syrup? No. Whiskey? Ok, well… maybe… but that’s different.

We do not buy ice cream in bulk. So why make the comparison?

I sell my product wholesale in bulk at around 50 cents per pound, I sell it retail to your average consumer at around 3$ per pound. Selling commodities in bulk is quite different to buying a luxury item per unit.
There is a difference, and to suggest anything otherwise is ignorant of basic market economics or it is disingenuous at best.

Ask yourself, why did Stossel compare gasoline to a gallon of ice cream?
He didn’t need to, but he did.
 
Written By: PogueMahone
URL: http://
The problems with the plan are many, but the most damning is that it will not work.

As has been pointed out, many banks are holding assets on their books that can only be sold, even at inflated values, at a price that will cause them to have a bigger problem than keeping them on the books and have us all "look the other way."

More importantly, 700 billion ain’t near enough.

Only half of the troubled loans that eventually will come due are mortgages anyway. That leaves a likely trillion dollars in losses not connected with this bailout.

Nor is 700 billion enough for the mortgages and related debt. Remember, the 700 billion to 1 trillion in mortgage losses still to come are on over 11 trillion in mortgage debt. They aren’t buying 700 billion in losses, but 700 billion in securities. That will hardly scratch the surface, and only then if they purposely over-pay for them.

This is the wrong approach in almost every way I can think of, and the list of reasons to not support it gets longer and longer the more I study it.



 
Written By: Lance
URL: http://asecondhandconjecture.com
We do not buy ice cream in bulk.
Speak for yourself buddy ;^)
 
Written By: Lance
URL: http://asecondhandconjecture.com
This is the wrong approach in almost every way I can think of, and the list of reasons to not support it gets longer and longer the more I study it.

I agree 100%.
 
Written By: David Shaughnessy
URL: http://
If you disagree with that, then you should ask yourself when was the last time you bought 30 gallons of anything other than gasoline. Milk? No. Soda? No. Pancake syrup? No. Whiskey? Ok, well… maybe… but that’s different.
The real scandal is the cost of single malt scotch. Single malt scotch is a requirement of Western civilization, yet it is waaay more expensive than gasoline.
 
Written By: Don
URL: http://
More importantly, 700 billion ain’t near enough.
My understanding is that the current "bipartisan agreement" has reduced that significantly.

However, it is good to keep in mind that anything the Democrats agree with will have to be a bad plan, by definition.
 
Written By: Don
URL: http://
"And if it Causes the Panic of 1819"

I’m pretty sure we already have a panic.
 
Written By: timactual
URL: http://
This is the wrong approach in almost every way I can think of, and the list of reasons to not support it gets longer and longer the more I study it.
And it’s all but done. No one can do anything but complain and maybe quake just a bit.

The things Bush stood there and said last night. And McCain saying this today:
McCain said a deal must be achieved by the time financial markets open on Monday to avoid economic calamity in the United States...

Time is short, and doing nothing is not an option," he said.
What’s so dreadfully godawful is that, by and large, most people can — do? — believe this.

Has it been 200 hours since this 700 billion dollar transfer of wherewithal was first proposed?

This is complete and utter insanity. Our friends in Washington are going to forestall wholesale economic collapse by throwing however many hundred billion dollars — at a time — wildly at a problem they created and we don’t have time to discuss?

If this can happen — and it’s happening — then anything anything anything can issue from Washington. And it will.
 
Written By: Linda Morgan
URL: http://
We do not buy ice cream in bulk.
Clearly he does not have teenage children :)
 
Written By: capt joe
URL: http://
Warren Buffett just bought Constellation Energy in Baltimore for $4.6 billion, and has invested $5 billion in Goldman Sachs. How come he can come up with a $10 billion+ dollars in these parlous times and no one else can? Has he been asked to the White House?

"This is complete and utter insanity"

Amen. Panic and a** covering time.
"When in danger, when in doubt,
run in circles, scream and shout"
 
Written By: timactual
URL: http://

 
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