Forget healthcare, I want their banking system!

Nick Rowe has some very useful info on the Canadian banking system.  I heard on NPR that during this crisis Canada went from having zero of the top 50, to having 5 of the top 50 banks in the world (in market cap.)  And they have only 33 million people.  I am a pragmatist, so that sounds like a good system.  Even the one regulation that is tighter (capital requirements) makes sense given the moral hazard from FDIC, too big too fail, etc.  Seems Obama is also a big fan of the Canadian system.  Maybe he’s a pragmatist too (let’s hope so.)

Here’s what Nick put in my comment section:

Nick Rowe
5. May 2009 at 09:00 (#)
Scott: I don’t really know why Canada’s banks seem to have done well (touch wood). Maybe we just got lucky

They have taken losses, but not bad enough to need bailing out. We had a mini-ABCP liquidity and solvency crisis, where it wasn’t clear whether the banks were on the hook, but it got sorted out. Our housing prices have only recently started falling, having peaked in mid-2008. Here’s our version of Case-Shiller: http://www.housepriceindex.ca/Default.aspx

But it doesn’t seem to be as simple as “Canadian banks are more tightly-regulated”.

1. We never had restrictions on interstate banking, so Canadian banks spread their assets and liabilities across Canada. (So it doesn’t matter if a local housing market goes bust).

2. We don’t have Glass-Steagal. The investment banks joined the retail banks some years ago.

3. We don’t have mortgage interest deductibility from taxes. So paying down your mortgage is a tax-free investment. So most people want to pay down their mortgages.

4. (Except in Alberta), mortgages are fully recourse. You can’t just walk away from a negative equity home and hand the keys to the bank; the bank will come after you for the difference.

I wouldn’t describe those differences as “Canada is more regulated”.

But we do have higher capital requirements. And mortgages over 80% must be insured (mostly by the government-owned CMHC).

The biggest and most important difference seems to be the *style* of regulation “” “principles-based” in Canada, vs “rules-based” in the US. And a difference in banking “culture”. I and my commenters discuss it here:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/canadian-vs-us-bank-regulation.html

But I really don’t know.

Notice that unlike me he pretends to know less than he really knows, it must be the Canadian culture.  If I knew that much about anything I’d consider myself an expert (as would many of my commenters.)  I can’t help pointing to his comment about the decline in the Canadian housing market.  I wonder why an otherwise healthy housing market would suddenly start declining in the last half of 2008.  Is there any model of the current crisis that could explain that fact?

P.S.  Readers might want to check out his links, especially the one on regulatory cultures.


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28 Responses to “Forget healthcare, I want their banking system!”

  1. Gravatar of Adam P Adam P
    5. May 2009 at 09:47

    Scott says “Notice that unlike me he pretends to know less than he really knows, it must be the Canadian culture.”

    I guess you didn’t know that I’m Canadian. It must be just Nick.

  2. Gravatar of ssumner ssumner
    5. May 2009 at 09:48

    Yeah, You and me are both pretty stubborn.

  3. Gravatar of bob bob
    5. May 2009 at 10:47

    ” I wonder why an otherwise healthy housing market would suddenly start declining in the last half of 2008. Is there any model of the current crisis that could explain that fact?”

    Well, I imagine that a large part of that decline was due to correlation with commodity prices. Strangely though, Alberta peaked before the highest oil prices, so that can’t be the whole story:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/location-location-location-canadian-house-prices-by-city.html

  4. Gravatar of a student a student
    5. May 2009 at 10:51

    I believe the UK is also “principles” based. It didn’t work out too well for them.

    Australian banks have done well. When I have asked people more knowledgeable than me why Australian banks avoided the problems, “a different business model” has been the reply. When I tried to dig a bit deeper, the answer involved something like not having to chase yield because they already had a stable income. I’m not sure how much economic sense that makes, but that’s at least what some people think. I wonder if that is also true for Canadian banks.

  5. Gravatar of David Stinson David Stinson
    5. May 2009 at 11:11

    “Even the one regulation that is tighter (capital requirements) makes sense given the moral hazard from FDIC, too big too fail, etc.”

    This point is a good one, I suggest hesitantly (I too am Canadian).

    George Selgin noted in his very interesting Econtalk interview (on free banking) that, during the Scottish experience in the first half of the 1800s, confidence in the free banks was based on their high levels of capital (some 30% of liabilities), not on their level of reserves. This allowed them to maintain very small levels of reserves (equal to 1 or 2% of deposits).

    One wonders whether, if regulation aimed at bank stability is required politically or economically, one good regulation based on an examination of what arose naturally in a free banking environment (i.e., high capital requirements) might be better than several regulations (FDIC, reserve requirements and lower capital requirements), at least one of which has unfortunate incentive effects. In that regard, I don’t think we have reserve requirements in Canada.

    Given the law of unintended consequences, my sense is that “belt” or “suspenders” is usually preferable to “belt and suspenders” when it comes to regulation (of any industry).

  6. Gravatar of Alex Golubev Alex Golubev
    5. May 2009 at 11:18

    easy does it. Canada is celebrating a bit prematurely. First, they didn’t get into the top 10, US declined from the top 10, which “exposed” the rest of the world banks. China’s banks IPO’d in the last few years as well and are now in the top 10, too. I’m voting nay for the chinese healthcare OR banking systems and yay for Molson. Second, their real estate charts don’t look that different from the rest of the world – just a bit lagged compared to CA and FL, but very similar to say Seattle or Portland. I’m in Seattle and folks here were going coocoo declaring that we have the strongest economy and a green premium in 2006-2007 while CA, FL, NV were tanking. Now Seattle lost WaMu while MSFT, SBUX, and BA are laying off people left and right. Unemployment in WA is now higher than in US. So, Canada, let’s wait for the fat lady to sing. Third, fully recourse is good, not from the loss severity point of view but from the borrower being too scared to walk away. Reality is that the house is the borrower’s biggest asset, so this works on a purely psychological level. 80% LTV is definitely good, but i seriously doubt that was the rule in Vancouver or any other frothy market. This goes back to the whoel idea that LEVERAGE doesn’t allow any room for mistakes. Fourth, it’s not that i don’t want the canadian banking system, it’s that i’d rather get rid of the American “dream” (of homeownership). I’m pretty sure that most dreams make for bad investments

  7. Gravatar of Sean DeCoursey Sean DeCoursey
    5. May 2009 at 12:00

    I might be mistaken here, but I was always under the impression that the reason Canada’s banks have done so well recently is because they’re basically government sanctioned monopolies that don’t face the intense competitive pressure that motivated so much keep up the risk taking with the Jones’ in the U.S. and Europe.

  8. Gravatar of Bill Woolsey Bill Woolsey
    5. May 2009 at 13:16

    The logic for capital requirements in the face of deposit insurance is impecable.

    The consequences have been problematic.

    The reason to require capital is to cushion losses in difficult times, allowing debtors to collect their funds and avoiding the costs of bankruptcy.

    When capital requirements in the form of ratios are applied in bad times, the use of existing capital as a cushion is rendered less effective. Instead of simply allowing capital to decrease as losses imply reduced assets and less net worth, required capital ratios require that banks either find new investors or else shrink their balance sheet. (The existing scheme of risk weighted capital requirements allow banks to shift from various sorts of loans to reserves–vault cash or balances on deposit at the central bank–or else goverment bonds.)

    What “should” happen is that banks will continue to hold and make new sound loans. And then gradually rebuild capital out of earnings from good loans. The capital shrinks during bad times (when the bank has an unusually large amount of losses because of bad loans) and then gradually rebuilds from profits on good loans.

    Now, if we are thinking of a single, small bank, that has bad loans, then, so what? If it must shrink its balance sheet, then the rest of the banking system can easily expand. They can (and will) retain earnings to obtain the profits available from additional market share. Or, perhaps, they could sell new stock. The banking industry is doing fine. The healthy have opportunity for further profit because a competitor has stumbled.

    This doesn’t mean that capital is effectively doing its job, but the use of capital ratio requirements directly imposes costs on bank stockholders and imposes the social costs of requiring bank customers to shift from one small bank to another.

    But suppose all banks are having difficulty? There are not enough strong banks to expand to meet loan demand. While they could all sell stock, the banking system is weak. It seems like a bad time to sell new stock. (The bad debt overhang, right?)

    So, capital requirements in the form of ratios imposed on banks that have “used up” their capital look to have counter productive effects with the losses are general on the banking system.

    I favor relaxing capital requirements now.

  9. Gravatar of Nick Rowe Nick Rowe
    5. May 2009 at 13:53

    Thanks Scott!

    What “a student” says about Australian banks would apply equally to Canadian banks, from what I hear. Each has a retail base. Reminds me of the so-called “345” model of banking. Borrow at 3%, lend at 5%, off to the golf course at 4pm.

    I agree with Alex though. Canadian house prices probably still have further to fall. We seem to have had a bubble too, especially in some areas. It looks like a lagged, but muted, version of the US. So it is still too early to be sure that Canadian banks are OK.

    Canada Mortgage and Housing corporation insurance rates (compulsory for less than 20% downpayment) seem reasonably steep. http://www.cmhc-schl.gc.ca/en/co/moloin/moloin_005.cfm Enough to discourage some from getting too big a mortgage (I know it discouraged me, when buying my first house).

    By the way, and relevant to Scott’s other themes, Canadian banks’ reserves at the Bank of Canada are very small, certainly in comparison to the Fed. But Government of Canada deposits at the Bank of Canada are very large. The Bank of Canada pays interest on reserves, currently at 0.25%. http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/04/the-evolution-of-the-bank-of-canadas-balance-sheet.html

  10. Gravatar of David Stinson David Stinson
    5. May 2009 at 14:16

    Hi Bill:

    “When capital requirements in the form of ratios are applied in bad times, the use of existing capital as a cushion is rendered less effective. Instead of simply allowing capital to decrease as losses imply reduced assets and less net worth, required capital ratios require that banks either find new investors or else shrink their balance sheet.”

    Would this not imply that any capital regulation be counter-cyclical – higher ratios in good times while allowing ratios to decline naturally in bad times as the cushion does its job (or something)?

  11. Gravatar of The Rich Have More « Blackadder’s Lair The Rich Have More « Blackadder’s Lair
    6. May 2009 at 05:12

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  12. Gravatar of The Rich Have More « Vox Nova The Rich Have More « Vox Nova
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    […] democratic direction (as I fear we may be) then we would do well to look more towards the sensible policies of some more socially democratic countries, rather than the sort of populist demagoguery that is […]

  13. Gravatar of ssumner ssumner
    6. May 2009 at 05:15

    bob, You’re right. And why did commodity prices fall through the floor in late 2008? What causes deflation?

    a student, Thanks for the comment about the UK. Do you know if they had different regulations on leverage?

    David, I agree that reserve requirements aren’t the key issue, they don’t prevent insolvency. Capital requirements may not work in the end, but they have a better shot of working than RRs. So I think we agree. I really like the way you think through the implications of free banking. I tried to make a similar argument in my “Bank Architecture” post about 3-4 weeks back, but applied to 1920s banking.

    Alex, Yes, I agree we should get rid of the “dream” of everyone having a home. Well put. On the comparisons with the U.S., in an earlier post I argued there were two housing collapses; 2007-08 in the subprime bubble markets, and a different collapse in late 2008 that was caused by NGDP falling sharply, not caused by subprime mortgages. That later collapse also seems to have involved Canada. The cause was tight money, not bad lending practices (as in the first collapse.)

    Sean, “monopolies?” plural? How many banks are there in Canada? I thought they had at least 10.

    Bill, Good point, why not much higher cap req. in good times, and then automatically loosen them if NGDP growth falls below a certain threshold?

    Note, “good times” for homeowners is not fast RGDP growth, it is fast NGDP growth.

    Nick, Thanks, but are you sure Canada had a housing bubble? I argue that only part of the U.S. story was a bubble, the other part (affecting state like Texas), was falling NGDP which only kicked in late last year. Is it possible that Canada was just hit by what the Austrians call “secondary deflation?”

    I have a question on the low ERs in Canada. I presume Canadian banks have better alternatives than holding lots of ERs. What are T-bill yields? Are they still finding loan opportunities? (I expect JKH to comment here, as I have a fundamental lack of knowledge of Canadian central banking.)

    David, I agree

  14. Gravatar of bob bob
    6. May 2009 at 06:36

    “bob, You’re right. And why did commodity prices fall through the floor in late 2008? What causes deflation?”

    Well, I’m not sure that you would agree, but this is my take:

    In the Fall of 2007 – Spring of 2008 the Fed was cutting furiously to preempt deflation. I think the idea was that debt deflation was in the cards due to all the falling asset prices and writedowns on the way, so Bernanke tried to get ahead of the curve by cutting even though CPI wasn’t falling.

    The problem is that at the same time they started the TARP-type programs that allowed the banks to avoid writedowns. I think that this backfired, because he stoked inflation expectations that were meant to neutralize the deflationary effects of declines in asset prices, without actually letting those assets decline. Maybe the case was that Bernanke was caught in a catch-22 situation. He needed the banks to carry out monetary policy, but the banks were holding so much bad debt that they were insolvent. If the losses were recognized there would be no banking system to speak of, but if the losses aren’t recognized monetary policy won’t work. I think he chose to save the banks at the expense of being able to carry out effective moneary policy through traditional means.

    What we got were very high inflation expectations and a sinking dollar in Spring ’08, without the countervailing balance sheet deflation. The situation was such that the bad debts were not written down, the market did not like the idea of hedging against inflation via equities (due to dodgy balance sheets), and so everyone rushed into oil and other commodities creating a large bubble in the spring of 08. The underlying market for oil was strong before the bubble formed, peak oil provided a rationale for high oil prices, and Chinese growth for the rest of the commodities. Seeing this, firms that needed to make up the losses they had taken in the previous year jumped into commodities head first. By July, the prices were absurd, and the whole thing just collapsed under its own weight. When deflation ensued, the Fed had already used up its traditional ammunition way before it should have, and wasn’t quick enough to shift towards alternative monetary policy.

    Long story short: the Fed jumped the gun > stoked inflation expectations without having the guts to let debt deflation run its course at the same time > blew a transitory commodity bubble > created a supply shock in the economy that worsened the situation > when the deflation actually came, the Fed was flat-footed and out of traditional ammo.

  15. Gravatar of Nick Rowe Nick Rowe
    6. May 2009 at 07:38

    Scott:

    It is not obvious to me that Canadian house prices generally were a bubble, though I think some markets at least probably were a bubble. Here is my attempt to figure out if they were over-priced at the peak, compared to rents: http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/11/are-canadian-houses-over-priced-a-revised-estimate.html

    The “secondary deflation” story is plausible, at least for some cities.

    Canadian banking is very concentrated. We have 5 big banks, 1 medium-sized one, that make up about 95% of the market, IIRC. A few years ago, 4 of the big banks wanted to merge into 2, but were not allowed to do so.

    Short-term T-bill rates seem to have followed the overnight rate very closely. So unlike in the US, where the T-bill rate fell below the deposit rate, there was no particular incentive for banks to hold large reserves on deposit at the Bank of Canada.

  16. Gravatar of ssumner ssumner
    6. May 2009 at 13:54

    Bob, I have a different view. I don’t think there were high inflation expectations at any time in 2008. I remember high inflation expectations in the 1970s. When you have high inflation expectations, bond yields soar. I also don’t think commodity markets “collapse under their own weight.” I believe that market prices move for a reason, changing expectations about future world growth, for instance. And I think the markets were right that growth was slowing unexpectedly fast. It turns out that the people who warned about high inflation in 2008 were wrong, and those who were more concerned about deflation (including Krugman to his credit) were right. And I think are still right. You may be right about the Fed running out of its “traditional ammunition” but if it had no backup plan for zero nominal rates, then it had no business engaging in interest rate targeting in the first place, or if it insisted on doing so they should have targeted inflation at 4% not 2%. Either way it was gross incompetence by the Fed and ECB. I was really gullible when I read all those articles by top economists insisting that monetary policy was highly effective at even zero rates. It is highly effective, but I was gullible in thinking that the rest of the profession believed that. Last November was a real wake up call for me.

    Nick, Thanks for that info. BTW, do foreign banks add competition to the Canadian market, or are their barriers? (de jure or de facto.)

  17. Gravatar of bob bob
    7. May 2009 at 04:34

    ” I don’t think there were high inflation expectations at any time in 2008.”

    True, inflation expectations never sustained a high level, but there were a few false starts that made a lot of people nervous. This post by Mankiw sums up a sentiment that was quite common at the time:

    Inflation Expectations are Rising
    http://gregmankiw.blogspot.com/2008/02/inflation-expectations-are-rising.html

    “A rise in expected inflation is not consistent with the conventional wisdom that the economy is on the verge of a serious slump driven by inadequate aggregate demand. It is, however, consistent with the hypothesis that policymakers are overreacting to some bad economic news with excessive monetary and fiscal stimulus.”

    Quite a few economists like Ken Rogoff were making similar points at the time, and the big worry was “stagflation”. That was the buzzword in early 2008. I never bought into that concept myself, but it did seem to influence a lot of people’s thinking at the time. That’s what I meant with my sloppy use of the term inflation expectations.

    In terms of commodities “collapsing under their own weight” what I mean by that is that the spot prices were driven up by futures far beyond what could be justified by supply vs. demand (Mark Thoma had a good post demonstrating the mechanics of how the futures market can get very far out of line with the fundamentals in the near term before correcting, without this showing up in inventories). By early July a) larger investors got nervous and started pulling out and b) serious demand destruction started to become evident. the prices could never have been sustained for anything longer than a few months (even in a healthy economy, oil above $100 would have been unsustainable IMO) and when this became evident there was a big rush to the exits. I think Ben Graham’s phrase that “In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine” is especially true of commodity futures. The votes were all for inflation & global growth, but when the weight readings started coming in they were proven disastrously wrong.

    “It turns out that the people who warned about high inflation in 2008 were wrong, and those who were more concerned about deflation (including Krugman to his credit) were right.”

    I was definitely with Krugman on this, but at the time (and on record) I was warning that the cuts were premature because the write-downs weren’t being taken, that they were therefore unlikely to work due to dysfunctional credit channels clogged with bad paper, and that they were likely to create a bubble in commodities via the effect of negative real interest rates and liquidity premia. People asked my why I was worried about commodity “inflation” if I though that we were headed into deflation, and my response was that monetary easing had pretty much 0 benefit due to the bad paper and lack of trust in the banking community, and would only fuel a bubble in commodities that would have adverse effects on the real economy. Maybe it’s confirmation bias, but this insight served me quite well.

  18. Gravatar of ssumner ssumner
    7. May 2009 at 17:46

    Bob, Those inflation expectations are 5-year, five year forward. That’s what I would call data mining. Why not simply 5 year expectations, which presumably should be the focus of monetary policy? I do remember that post, and I am not saying money should have been easier at that time (February), but I doubt NGDP growth expectations were high at that time, and that’s what the Fed should focus on. If all we care about is inflation, why are we spending 800 billion on fiscal stimulus? It is obvious we care more about NGDP than P, it’s just that mainstream economists keep talking about “inflation targeting” like that’s the only objective of the government.

    Because I favor NGDP targeting, stagflation doesn’t concern me at all (as a monetary policymaker, obviously it concerns me as a citizen.) I favor 5% NGDP growth regardless of what is happening to commodity prices or real NGDP. If 5% NGDP targeting creates a commodity bubble, that’s find with me. Commodity bubbles do zero harm to the economy as long as NGDP is growing at a satisfactory rate. Indeed in late 2007 and the first half of 2008 NGDP only rose at a 3.3% rate. That’s tight money by my definition, regardless of what was happening to (meaningless) nominal interest rates. Commodity prices rose because of the boom in Asia, which at that times was expected to continue. If I thought $140 oil was unsustainable for more than a very short period of time I would have sold it short and I would be rich now. I am not rich; congratulations to anyone who did sell oil short at $140. I agree that speculation can drive up futures prices, but not spot prices unless there is physical speculation in oil (hoarding). Maybe Thoma thought oil was being held back in the form of “mechanical problems”, I didn’t read his post. Maybe there was some of that, but at the time most articles I read said there was nothing unusual about oil consumption at the peak. And if consumption held up, then speculators may have thought the price was sustainable.
    I think all of your points are defensible, I’m just not convinced.

    Back to the stagflation point. I really don’t understand mainstream economists when they talk about stagflation. James Hamilton said we shouldn’t have had easy money in early 2008 because that blew up the commodity bubble and caused the downturn in the fall. The recession officially started in December 2007—what macro model says you should tighten money in the early stages of a recession, in order to make the recession milder? That seems like a hunch looking for a theory. The stock market was clearly signalling it would collapse in early 2008 without major Fed easing—that’s why the Fed reversed course so quickly after blowing it in December 2007. All tight money in early 2008 would have done is caused the crash of 2008 in the spring rather than the fall. The crash was not caused by high commodity prices, it was caused by deflation of all sorts of asset prices, brought on by tight money.

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  27. Gravatar of commonwealth commonwealth
    26. August 2009 at 19:34

    A VOXEU column and an IMF working paper argues that Canadian banks have been more resilient because they rely on more stable retail deposits from households instead of short-term wholesale funding from interbank markets. They also propose a Pigovian tax on short-term wholesale funding to get other banks to do the same.
    http://www.voxeu.com/index.php?q=node/3901

  28. Gravatar of ssumner ssumner
    27. August 2009 at 03:05

    commonwealth, Thanks, but I am a bit skeptical. Surely the big problem wasn’t the US banks’ reliance on wholesale funding, but that they made a lot of bad loans that the Canadian banks didn’t make.

    I’m not saying these guys are wrong, but I just don’t see it as the big problem. I don’t think it would prevent a repeat of the subprime fiasco.

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