The Goldman Sachs Forensic Analysis

By: Reggie Middleton | Fri, Jul 25, 2008
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Here is my detailed opinion on Goldman Sachs. Be sure to review my precursor to this report: Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street. Anybody who is interested in how I think should read this report carefully. I believed GS to be significantly overvalued to begin with, and sporting a high share price wards off the small time bears and short sellers, not to mention the SEC put option assignment through the prejudicial short seller rule protection, combined with the recent and totally non-fundamental financial industry rally has created a shopping opportunity for me in which I stocked up on puts. Needless to say, I am quite bearish and heavily short. Below is sneak peak of from the guts of the opinion.

About half of the reduction in the level 3 assets resulted from transfer to level 2 assets: In 2Q2008, Goldman Sach's reported level 3 assets declined 19% to $78 bn from $96 bn in 1Q2008 primarily due to $12.6 bn of transfers and $2.2 bn of assets sale. In spite of this, Goldman Sachs continues to have the highest level 3 assets among its peer group, 13% higher than its closest competitor Morgan Stanley whom I had granted the title, the Street's Riskiest Bank. The highest level 3 asset level had belonged to Bear Stearn's, and I had sternly warned of this company's potential failure in January of '07, see Is this the Breaking of the Bear?. My short position was established in November of '07 and by the time of their collapse, it was my portfolio's largest position. There are similarities between some of the weaknesses in Bear Stearns and Goldman Sachs. See some of the background reading available from my blog (keep in mind that these articles pre-date the collapse of the share price of these companies by months at the very least):

Now, on to the opinion report. The HTML version here does not include the assumptions and pro formas (an additional 10-12 pages of supporting data), and the graphics are admittedely distorted. No need to fret, registered users of the blog can download the full fidelity, high resolution printable copy here: GS Report_072108-2 (361.18 kB 2008-07-24 15:20:25). As an added bonus, I'll throw in the Goldman Sachs Ambac/MBIA insured ABS, MBS and CDO inventory just for good measure. This will come in handy when reading the portion of the report that details the declining asset value and high Level 3 concentrations of the Street's Golden Boys. See GS ABS Inventory (1.22 MB 2008-02-25 06:48:56).

I. Investment Summary

Until now Goldman Sachs (GS) has withstood the ripples effect of plummeting financial and capital markets, and widespread losses and write downs in the US mortgage backed securities market. Almost all of its peers including Merrill Lynch (ML), Morgan Stanley (MS) and Lehman Brothers (LEH) posted huge losses off write-downs in their trading and investment portfolios in the first two quarters of 2008 while GS has been able to contain its losses off relatively better quality of its assets, and managed to offset these from gains off its more favorable derivative positions. With problems in the financial markets expected to continue beyond 2008, we expect the operating performance of GS to be impacted by the deteriorating global macroeconomic environment given its high exposure to level 3 assets (197.6% of tangible shareholders equity) and high leverage (adjusted leverage of 14.7x). In addition, a continuous rise in its VaR (a measure of potential loss in value of trading positions due to adverse market movements) as a result of increased volatility and widening of spreads in the underlying investment assets could dampen GS trading revenues (currently being the highest amongst its peers group and comprising nearly 30% of its revenues before interest expense). Moreover, we believe that lackluster M&A business volumes could further lead to softening of investment banking revenues in the near-to-medium term. Based on our relative valuation of GS vis-à-vis its peer group, we have arrived at a per share valuation of GS at $144.3, implying a potential downside risk of 21.1% from its current per share price of $182.8.

II. Key points

Banks' valuation likely to be impacted by continuing tumbling of the US financial sector: Continuing financial crisis, further reinforced by collapse of Freddie Mac and Fannie Mae, is likely to hit US banks' valuation as widespread negative sentiments continue to grip the markets. The dwindling investor confidence is reflected by record high corporate bond spreads and plummeting price multiples. Banks including investment banks like Goldman Sachs are likely to be adversely hit as the risk attached to such businesses are expected to get re-priced. In addition, the specter of significantly increased regulation is coming down the pike, compressing leverage, hence margins in an attempt to quell the potential for systemic financial market disruption.

GS' high market risk reflects the bank's high stakes on the fate of the global financial markets: GS' relatively high and consistently rising trading VaR and its increased exposure to other market risks (not represented by VaR) indicate increased volatility that GS trading portfolio is exposed to. The current volatile financial and capital markets will certainly test GS' ability to withstand probable increases in losses in its trading portfolios in the coming periods.

High financial risk reflected by adjusted leverage ratio: GS scores relatively low among its peers in terms of the adjusted leverage ratios, representing higher financial risk. Although the second quarter saw a noticeable fall in GS' adjusted leverage ratio to 14.7x from 18.6x in 1Q2008, following a $100 bn trim down in total assets, the ratio still remains higher than those of its peers.

Massive off-balance sheet exposure of probable losses from unconsolidated Variable Interest Entities (VIEs): With GS' maximum exposure to loss in unconsolidated VIEs standing at $22.2 billion, representing nearly 50% of the total shareholder's equity, compared to similar figures of 26% and 4% for Morgan Stanley and ML, respectively, GS assumes a far higher off-balance sheet risk. Further, the exposure is in some of the riskier and troubled asset categories like CDOs, CLOs and real estate securities, held indirectly through its unconsolidated VIEs, which is likely to dent GS' performance in coming periods.

Illiquid level 3 assets forming a relatively higher proportion of adjusted total assets: With a relatively high level of level 3 assets as percentage of total assets and as percentage of shareholders' equity compared to its peers, GS could run risk of higher write downs, particularly on mortgage backed securities, as spread continue to widen and investors appetite for risk continue to decline. Although these ratios witnessed a decline in the second quarter of 2008 due to transfers to level 2 assets, GS continue to have sizeable exposure in high risk Alt-A and subprime residential mortgage-backed securities.

Tough times anticipated in GS core businesses: GS' core businesses are likely to get hit by continuing global slowdown in the capital market activities. Slackening M&A, IPO and bond issuance activities are likely to impact the investment banking revenues while lower investors' risk appetite and continuing negative returns in equities will probably slow-down GS' trading and fee-based asset management income, in our view. The exception to this would be those proprietary and client driven volatility trading desks that attempt and may succeed at benefitting from extremes in volatility. This is a dual edged blade though, for these trading strategies often carry higher inherent risks, higher VaR, and lower risk adjusted returns than the more plain vanilla businesses. Basically, when the doo doo hits the fan in these businesses, it tends to splatter farther than normal - splashing any business units that may be standing around.

GS' asset quality has declined over the past two quarters : The proportion of non-investment grade securities in GS' trading and investment portfolio has increased over the last two quarters. Though GS' liquidity position remains strong, exposure to riskier assets raises concerns about write downs in the near future. This is expected to be exacerbated in the very near future due to the fact that there are no longer any insurers who have, and who are wrapping derivative securities that have a AAA or Aaa rating that is not on negative watch for prospective downgrade. This translates into a literal dearth of high end investment grade derivative instruments that relied on monoline insurance wraps. It also means that the implicit leverage inherent in overcollateralization (a method of pursuing a higher credit rating for security by pledging more than 100% collateral to a deal) may very well come home to roost in unexpected ways. {mospagebreak}

III. Valuation

Considering the volatility of earnings of financial and banking institutions, and their relative balance sheet strength to withstand the current deteriorating macro-economic conditions, we believe relative valuations based on a P/B approach will reflect the company's current valuation better than valuations based on future stream of income based on DCF and P/E approaches. Using an average 2009 adjusted P/B multiple of 1.27x (after applying a 25% premium for the sake of conservatism, recognizing that the market places a premium on the Goldman Sachs brand), we calculate GS' per share valuation at $144.2, representing a 21.1% lower valuation from its current price of $182.8.

Adjusted P/B based valuation

We have valued GS based on adjusted P/B multiple. Based on adjusted P/B of 1.02x for 2009 for its peer group and applying a premium of 25%, GS' valuation comes to $148.5 per share (excluding loss from unconsolidated VIE's, again in an effort to come to a conservative conclusion), with a downward potential of 18.8% from the current share price of $182.8. It is quite likely that losses will emanate from unconsolidated VIEs.

Including losses from unconsolidated VIE's of $1.5 bn (after-tax), GS book value per share for 2009 is expected to be $113.6. Based on P/B multiple of 1.27x (2009 P/B multiple of peer group and a 25% premium), GS fair value per share is approximately $144.3 with a downward potential of 21.1% from current share price of $182.8.

IV. Investment Highlights

Valuations likely to be impacted by continuing tumbling of the US financial sector

Collapse of Freddie Mac and Fannie Mae indicating no-near end of the financial crisis: Rapidly dwindling confidence in the US financial sector following widespread losses and write-downs in the underlying securities held by financial and banking institutions has necessitated a revisit to the valuations these institutions are trading at. A sharp rise in credit default swaps (CDS) for some of the largest commercial and investment banks in the US over the last few weeks indicate a lowering investment confidence at the current level of valuation. With Freddie Mac and Fannie Mae losing about 80% of their value this year off rising mortgage worries in the form of increasing delinquencies and defaults, the problems in the financial market seem far from over.

Spreads for financial corporate bonds, measuring investors' risk appetite, have widened to their highest level in two years to 344 basis points over US Treasuries, indicating a larger probability of further distress. With returns from the banking and financial sector not expected to improve significantly over the next 12-18 months, the period of negative returns will continue at least till the end of the second half of 2008 and probably through 2010, in our view.

Decline in price multiples for investment banks to continue off expected widening of spreads and increasing write-offs: Morgan Stanley, LEH and ML, which were trading at an average two-year forward P/B multiple of 1.39x at the beginning of this year, are now trading at 1.02x. The trend in declining valuation is expected to continue till losses off write-downs and loan losses of investment banks decline to the pre-sub prime crisis level and investors' confidence in the financial and capital markets is reposed. We expect GS' valuation to follow the decline in peer group multiples in the near-to-medium term, and estimate a downside of 21.1% in its current price of $182.8. Amid escalating inflation pressure and widespread write-downs witnessed by banks, which has forced Fed into a "tennis-neck" syndrome, a perfect solution to the current crisis has not yet come to light.

Goldman Sach's towering market risk reflects the company's high stakes gambit on the fate of the global financial markets

Rising trading risk off consistent increase in VaR: Goldman Sach's consistently rising trading VaR indicates the increased volatility that Goldman Sach trading portfolio is exposed to amid current deteriorating capital and financial market conditions. Goldman Sach's average daily VaR (at 95% confidence level) increased a significant 38.3% to $184 mn in 2Q2008 from $133 mn in 2Q2007. This was much higher than the 2Q2008 figures of $99 mn for Morgan Stanley and $123 mn for LEH. In 2Q2008 VaR for Morgan Stanley increased by a modest 2.1% over 1Q2008, and declined 15.4% for Lehman, in contrast to a 17.2% increase for Goldman Sach. The company also stands to lead its peers in terms of ‘VaR as a percentage of equity shareholder's equity' at 0.41% (up from 0.36% in 4Q2007), next only to Lehman. With financial and capital markets continuing to remain volatile and uncertain in a very, very difficult macro-economic environment, Goldman Sach's high level of VaR is likely to test its ability to withstand an expected increase in losses in its trading positions.

Based on latest quarterly filings. Merrill Lynch has not yet disclosed its VaR numbers

In May 2008, Goldman Sach's VaR peaked to $214 mn with an average VaR of $194 mn (with a potential of wiping off 0.43% of shareholder's equity once in every 20 trading days), up from $171 mn in February 2008. Also, the fact that Goldman Sach's trading losses incurred on a single day exceeded its one-day VaR on three occasions during 2Q2008 compared with two in 1Q2008 indicate a higher likelihood of trading losses for Goldman Sach in the second half of 2008.

The chart below shows a comparison of Goldman Sach and Morgan Stanley (arguably, the Streets 2nd most prolific proprietary trading house) based on number of days their trading losses increased their respective VaRs in last four reported periods. While Morgan Stanley witnessed trading losses (higher than its VaR) on more days (numerically) in 3Q2007 and 4Q2007 as compared to Goldman Sach, the trend has been reversed in the first two quarters of 2008, indicating a riskier trading portfolio for Goldman Sachs.

The increase in other market risks for positions not included in reported VAR acts as an additional dampener on value: Beyond the realm of normal loss expectations denoted by VaR which is based on historical data, there are other potential undirected and unpredicted market risks not captured by VaR. These market risks stem from Goldman Sach investments in debt, real estate, equity, unspecified special purpose vehicles (SPEs) and other investments subjected to transfer restrictions and/or illiquidity, and are measured by a potential reduction in the asset value of the investment or performance of the investee entity. The potential risk in loss of value of these investments for Goldman Sach in 2Q2008 was $5.7 bn, a staggering 66.2% increase from $3.5 bn in 2Q2007. These risks and liabilities apparently have not been factored into the valuation of Goldman by those entities and pundits who fail to perform full forensic analyses, or who simply follow the crowd.

In addition to the market risk, Goldman Sach is exposed to several non-market non-quantifiable risks including counterparty credit risk and funding risk. The CDR Counterparty Risk Index, which measures counterparty risk of major credit derivative dealers increased to 179.4 basis points on July 15, 2008, the weakest since March 2008 when Bear Stearns had collapsed. Increased counterparty risk and heightened volatility in the capital markets could result in higher trading losses for Goldman Sach which derives nearly 30% of its revenues (before netting off interest expense) from its trading desk. I'd like to add that this proportion of revenues will probably increase as fee based services and securitization services ebb and dwindle to next to nothing, respectively.

Based on latest quarterly filing from Goldman Sachs

Goldman Sach's higher leverage ratios represent high financial risk

Goldman Sach's scores low among its peers in terms of financial risk reflected by adjusted leverage ratio: Goldman Sach's has always been in a tight spot when compared with its peers based on adjusted leverage ratio. Given the level of caution displayed by the investor community, high financial risk emanating from a relatively higher leverage ratio is likely to dent Goldman's position compared to its peer group. Although growing concerns from shareholders and regulators over a relatively high leveraged balance sheet drove Goldman to trim down its assets by about $100 bn in 2Q2008, bringing down the adjusted leverage ratio to 14.7x from 18.6x in 1Q2008, Goldman Sach has not been successful in bringing down its adjusted leverage ratio to levels reported by its peers.

Based on latest quarterly filings *Reported figures
NR- not reported. Merrill Lynch has not reported its adjusted leverage and total assets in the Q2 2008 earnings release on July 18, 2008

Massive off balance sheet exposure through unconsolidated Variable Interest Entities could result in losses in the form of commitments and guarantees

Goldman Sachs has substantial off-balance sheet exposure to riskier assets like CDOs, CLOs and real estate securities held indirectly through its unconsolidated VIEs. As of May 30, 2008, the total exposure (in terms of maximum loss to Goldman Sachs) stood at $22.2 bn, representing 50% of its total shareholders equity. This was significantly higher than 26% and 4% of shareholders' equity for Morgan Stanley and ML, respectively, in 2Q2008.

Of Goldman Sachs' total maximum loss exposure of $22.2 bn, nearly 40% is contributed by mortgage CDOs, with a substantially higher loss rate ratio of 46.6%. Amid current dismal state of the CDO market triggered by US housing woes and further aggravated by liquidity pressures, potential losses from unconsolidated VIEs alone could nearly wipe off half the company's shareholder's equity under the worst case scenario. In the wake of the tough times expected in the mortgage and asset backed markets, we expect Goldman Sachs to incur about $1.5 bn of its losses from unconsolidated VIEs, translating into loss rate of 2.2%.

Despite transfer of assets into the level 2 category, Goldman Sach's level 3 assets remain the highest among its peers.

About half of the reduction in the level 3 assets resulted from transfer to level 2 assets: In 2Q2008, Goldman Sach's reported level 3 assets declined 19% to $78 bn from $96 bn in 1Q2008 primarily due to $12.6 bn of transfers and $2.2 bn of assets sale. In spite of this, Goldman Sachs continues to have the highest level 3 assets among its peer group, 13% higher than its closest competitor Morgan Stanley whom I had granted the title, the Street's Riskiest Bank. The highest level 3 asset level had belonged to Bear Stearn's, and I had sternly warned of this company's potential failure in January of '07, see Is this the Breaking of the Bear?. My short position was established in November of '07 and by the time of their collapse, it was my portfolio's largest position. There are similarities between some of the weaknesses in Bear Stearns and Goldman Sachs. See some of the background reading available from my blog (keep in mind that these articles pre-date the collapse of the share price of these companies by months at the very least):

At the end of 2Q2008, Goldman Sach's level 3 assets stood at 198% of tangible shareholder's equity, next only to Morgan Stanley at 226%. Earlier, in 1Q2008 Goldman Sach's level 3 assets to adjusted equity had peaked to 258% before reducing in 2Q2008 due to transfer into level 2 assets (note that this was not a disposition of assets, but an accounting transfer - the risk is still on the books). However, despite very aggressive efforts to reduce its level 3 assets through a combination of accounting moniker transfers and sale transactions, Goldman Sachs still had a sizeable 7.2% of its adjusted total assets in level 3 assets in 2Q2008, which was still the highest among its peers. Level 3 assets, which are traded very thinly and with no observable market price thus has valuations dependent on management assumptions, are most vulnerable to mark-to-market write-downs. Level 3 assets write-downs for Goldman Sach, which were until now shielded from loss by favorable derivative positions (and gains resulting there from), could increase in the future with widening of credit spreads off deteriorating macro-economic and financial market conditions. We expect Goldman Sachs to report losses of $2.1 bn and $3.6 bn from level 2 and level 3 assets in 2H2008 and 2009, respectively. {mospagebreak}

NR- not reported. Merrill Lynch has not reported its level 3 assets and total assets in the Q2 2008 earninGoldman Sach release on July 18, 2008

Relatively high level 2 assets as a percentage of tangible shareholders equity: In 2Q2008, Goldman Sach's level 2 assets increased 39.0% y-o-y to $562 bn despite a 9.5% q-o-q reduction over 1Q2008 as a result of sale of assets, and stood at 1,422% and 52% of its tangible shareholders' equity and total adjusted assets, respectively. This was significantly higher than the figures of 892% and 27% for Morgan Stanley, and 730% and 26% for Lehman Brothers, in 2Q2008. If one were to compare this to the now defunct Bear Stearn's level 2 and 3 to tangible equity positions, it would be most unfavorable, indeed.

NR- not reported. Merrill Lynch has not reported its level 2 assets in the Q2 2008 earnings release on July 18, 2008

Possible rise in losses in level 3 mortgage backed securities: Following significant sell-offs in residential and commercial mortgages in the second quarter of 2008, mortgage backed securities accounted for 22.9% of Goldman Sach's total level 3 assets in May 2008, as against 25.9% in February 2008. However, asset sales were primarily in commercial mortgages and prime residential mortgages while the levels of the riskier Alt-A and subprime securities were more or less maintained. Any further widening of spreads off a speculation of increased losses and write-downs by financial institutions and banks could trigger another, significant markdown of asset-backed securities, particularly in Alt-A and sub prime categories. As such, the remarkable decline (or more accurately, the lack thereof) in total mark-downs of $0.9 billion in level 3 cash instruments (primarily comprising losses on bank loans, bridge loans, corporate debt securities and other debt obligations) in 2Q2008 from $2.9 billion (primarily comprising losses on mortgage backed securities) in 1Q2008 is not expected to repeat at least in the last two quarters of 2008.

Also, it is worthwhile to note the ABX indices consistently continue to fall amid rising housing woes and fast declining prices, raising concern over more write-offs in the coming periods.

ABX AA index

(Jan 10, 2007 to July 17, 2008)

CMBX AA spread index

(Jan 10, 2007 to July 17, 2008)


Tough times anticipated in Goldman Sach core businesses in light of the continuing slowdown in the global capital market activities

Global M&A slowdown is mirrored in Goldman Sach's slowing M&A deals: Tightening global credit situation and growing economic uncertainty, resulting in a significant pull-down of M&A deals in the first half of 2008, have had a significant impact on Goldman Sach's investment banking revenues. In the first half of 2008, revenues from Goldman Sach's advisory services declined from $1,570 mn to 1,463 mn in the corresponding period in 2007. The number of deals completed by Goldman Sach declined from 575 in the first half of 2007 to 368 in the comparable period of 2008. Weakening corporate balance sheet, decreasing appetite for global M&A and perception about further fall in valuation multiples, particularly in the emerging economies, are holding up M&A transactions. In addition, with capital market activities not expected to revive in the near-term, revenues for Goldman Sachs from its investment banking business will be impacted in the second half of 2008 and early 2009, in our view.

Equity and debt underwriting hit by global IPO and bond issuance slowdown: Fast declining stock market valuation multiples and weak economic outlook have put-off a number of new equity and debt offering planned for the first quarter of 2008. According to the Global IPO trends report 2008 by Ernst & Young, globally only $40.9 billion was raised through 236 IPOs in the first three months of 2008 as against $287 billion raised through 1979 IPOs in whole of 2007. This is a very significant slowdown that will hurt all in this space, from the leader to the laggard, and it gets worse . According to the data released by Dealogic, the number of IPOs completed globally dwindled to just 188 in the next three months of 2008. The situation is much worse in the US where the number of IPOs (excluding REITs and SPACs) filed from January 1 to June 20 in 2008, fell to 56 from 140 in the similar period in 2007. Further, during the period the number of IPOs hitting the market fell to just 23 from 91, while the number of IPOs postponed or withdrawn due to adverse market conditions rose to 41 versus 13 last year.

Goldman Sachs witnessed a sharp fall in its underwriting revenues, declining to $1,394 mn in the first half of 2008 from $1,867 mn in the first half of 2007. The number of equity offerings completed by Goldman Sachs in the first two quarters of 2007 stood at 31 as against 34 in the first half of 2007. Although these numbers are dismal, they have yet to match the drop witnessed in the actual equity offering market available to underwrite, hence we see a sharper drop in revenues.

On the debt side, Goldman Sachs underwrote 123 new offerings in the first half of 2008 compared to 194 and 312 in the first half and full year of 2007, respectively. While the US mortgage-backed securities issuance plunged 81.1% to $117.8 billion in the first six months of 2008 from $622.1 billion in the same period last year, US investment-grade corporate bond issuance witnessed a slowing trend, declining 31% q-on-q in the first quarter of 2008. The trend is not expected to reverse in the near future as market sentiments remain subdued, the credit markets in general are deteriorating and valuations are not perceived as attractive at the current levels.

Continuing crisis in the global capital markets likely to impact trading and fee based revenues: The global investment landscape continues to be hit by inflationary pressures in various economies of the world as well as by the mortgage crisis in US. While on the one side, food and oil price induced inflation is likely to threaten the global economic growth, on the other side the housing crisis in US continues to haunt the US market and cause a spill over effect on markets in other parts of the world, both in terms of a contagion and as a catalyst for most of the major developed and many of the emerging markets have their own housing bubble to contend with. As a result, a high level of caution and skepticism is likely to stay at least till the end of the year 2008.

This, in our view, will have a serious bearing on Goldman Sach's trading revenues off slowing capital and financial market activities. Further, the asset management business of Goldman Sachs is likely to get hit by reduced investment activities and movement in assets under management from high margin equity segment to relatively low margin fixed income and money market segments.

Goldman Sach's asset quality has downgraded over the past two quarters

Proportion of lower rated over-the-counter (OTC) derivatives has witnessed an increase over the last two quarters : Of Goldman Sach's total derivative position as of May 2008, which comprised nearly 29.3% of total financial instruments as against 23.3% and 28.2% as of November 2007 and February 2008, respectively, around 89% is OTC traded. Without the aid of centralized clearing exchange, we have the introduction of counterparty risks, opacity in pricing/valuation and liquidity issues. Over the last two quarters, the proportion of OTC derivatives rated below A/A2 has increased from 21.6% in 4Q2007 to a significant 29.2% in 2Q2008, raising concerns over deteriorating quality of Goldman Sach's derivative positions.

Although the mortgage backed exposure shrunk substantially, some of the more risky components remain intact : After substantial and aggressive asset dispositions in 2Q2008, mortgage-backed securities accounted for 9.1% of the total financial instruments owned against 10.4% at the end of February 2008. The net reduction of $14 billion in the mortgage backed securities primarily resulted off about $4 billion and $2.5 billion of sales in the residential and commercial real estate backed securities, respectively, and net decline of $7.6 billion in the other loans backed by commercial and residential real estate collateral. However, a closer examination reveals that the reduction in the residential-backed securities was primarily in the prime segment while the more vulnerable Alt-A and sub-prime securities did not witness any significant decline. Further, while the reduction in the commercial real estate-backed securities was entirely under the level 3 assets, the reduction in other loans backed by real estate collateral was almost entirely under level 2.



Reggie Middleton

Author: Reggie Middleton

Reggie Middleton

Reggie Middleton

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