Richard Stanton's Papers
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Published and Forthcoming Articles
- "Pricing Continuously Resettled
Contingent Claims", Journal of Economic Dynamics and
Control 16, 561-573, 1992 (with D. Duffie).
- "Rational Prepayment and the
Valuation of Mortgage-Backed Securities", Review of Financial
Studies 8, 677-708, 1995.
- "ARM Wrestling: Valuing
Adjustable Rate Mortgages Indexed to the Eleventh District
Cost of Funds", Real Estate Economics 23, 311-345, 1995
(with N. Wallace).
- "A New Strategy for Dynamically
Hedging Mortgage-Backed Securities", Journal
of Derivatives 2, 60-77, 1995 (with J. Boudoukh,
M. Richardson and R. Whitelaw).
- "Unobservable Heterogeneity
and Rational Learning: Pool Specific vs. Generic Mortgage-Backed
Security Prices", Journal of Real Estate
Finance and Economics 12, 243-263, 1996.
- "Pricing Mortgage-Backed
Securities in a Multifactor Interest Rate Environment: A Multivariate
Density Estimation Approach",
Review of Financial Studies 10: 405-446, 1997 (with J. Boudoukh,
M. Richardson and R. Whitelaw).
- "A Nonparametric Model of Term
Structure Dynamics and the Market Price of Interest Rate Risk",
Journal of Finance 52: 1973-2002, 1997 (nominated for
Smith-Breeden award).
- "Mortgage Choice:
What's the Point?", Real Estate Economics 26:
173-205, 1998 (with N. Wallace).
- "Anatomy of an ARM: The
Interest Rate Risk of Adjustable Rate Mortgages",
Journal of Real Estate Finance and Economics 19, 49 - 67, 1999
(with N. Wallace).
- "Nonparametric
Mortgage-Backed Security Pricing", in Advanced Fixed
Income Valuation Tools, John Wiley, 2000 (with J. Boudoukh,
M. Richardson and R. Whitelaw).
- "From Cradle to Grave: How to
Loot a 401(k) Plan", Journal of
Financial Economics 56, 485-516, 2000.
- "MaxVaR: Long-Horizon Value at Risk in a
Mark-to-Market Environment", Journal of
Investment Management 2, 1-6, 2004 (with J. Boudoukh,
M. Richardson and R. Whitelaw).
- "An Empirical Test of a Two-Factor Mortgage
Valuation Model: How Much Do House Prices Matter?",
Real Estate Economics 33, 681-710, 2005 (with C. Downing and
N. Wallace).
- "Managerial Ability, Compensation, and the
Closed-End Fund Discount", Journal of
Finance 62, 529-556, 2007 (with J. Berk) (nominated for Smith-Breeden award).
- "Evidence on Simulation Inference for Near
Unit-Root Processes with Implications for Term Structure
Estimation" forthcoming, Journal of Financial
Econometrics (with G. Duffee).
- "An Empirical Test of a
Contingent Claims Lease Valuation Model" forthcoming,
Journal of Real Estate Research (with N. Wallace).
- "A Liquidity-Based Theory of Closed-End Funds"
forthcoming, Review of Financial Studies (with M. Cherkes and
J. Sagi) (winner, Best Paper award, Utah Winter Finance
Conference, 2006).
Working Papers and Research in Progress
- "Human Capital, Bankruptcy
and Capital Structure", 2007 (with J. Berk and J. Zechner).
- "Optimal Exercise of Executive Stock
Options and Implications for Firm Cost" (with
J. Carpenter and N. Wallace), 2007.
- "Volatility, Mortgage Default, and CMBS
Subordination" (with C. Downing and N. Wallace), 2007.
- "Accounting for Employee Stock
Options" (with M. Rubinstein), 2004.
- "Valuing Mutual Fund
Companies" (with J. Boudoukh, M. Richardson and R. Whitelaw), 2003.
- "A Multifactor, Nonlinear, Continuous-Time Model of
Interest Rate Volatility", 2000.
(with J. Boudoukh, M. Richardson and R. Whitelaw).
- "Estimation of Dynamic Term Structure Models", 2004 (with G. Duffee).
Abstracts of Published/Forthcoming Articles
(with Darrell Duffie)
Journal of Economic Dynamics and Control 16, pp. 561-573, 1992.
Abstract
This paper is a study of continuously resettled contingent claims
prices in a stochastic economy. As special cases, the relationship
between futures and forward prices is analyzed, and a preference-free
expression is derived for these prices, as well as the price of a
continuously resettled futures option, whose formula differs from
Black's futures option pricing formula due to the effects of
marking-to-market the changes in the futures option premium.
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Review of Financial Studies 8, pp. 677-708, 1995.
Abstract
This article presents a new model of mortgage prepayments, based on
rational decisions by mortgage holders. These mortgage holders face
heterogeneous transaction costs, which are explicitly modeled. The
model is estimated using a version of Hansen's (1982)
generalized method of moments, and shown to capture many of the
empirical features of mortgage prepayment. Estimation results
indicate that mortgage holders act as though they face transaction
costs that far exceed the explicit costs usually incurred on
refinancing. They also wait an average of more than a year before
refinancing, even when it is optimal to do so. The model fits
observed prepayment behavior as well as the recent empirical model of
Schwartz and Torous (1989). Implications for pricing
mortgage-backed securities are discussed.
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(with Nancy Wallace)
Real Estate Economics 23, pp. 311-345, 1995.
Abstract
This paper analyzes adjustable rate mortgages (ARMs) based on the
Eleventh District Cost of Funds Index (EDCOFI). We study the behavior
of EDCOFI over the period 1981-1993, and find that adjustments in
this index lag substantially behind term structure fluctuations. We
also find that the seasonality and days-in-the-month effects noted by
previous authors are really symptoms of a "January effect".
Due to the lag in EDCOFI, if interest rates fall,
mortgage holders may want to refinance their mortgage loans to avoid
paying a coupon rate that exceeds the market rate. We develop a
finite difference valuation algorithm which accounts for all usual ARM
contractual features, in addition to the dynamics of EDCOFI. The
advantage of our pricing algorithm over commonly used simulation
strategies is that it allows us to determine endogenously the optimal
prepayment strategy for mortgage holders, and hence the value of their
prepayment options. We find that the dynamics of EDCOFI give
significant value to this option, typically around 0.5% of the
remaining principal on the loan. Our algorithm permits issuers and
investors in ARMs based on EDCOFI to quantify the effects of the many
interacting contract features, such as reset margin, coupon rate caps
and reset frequency, that determine mortgage value.
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(with Jacob Boudoukh, Matt Richardson and Robert Whitelaw)
Journal of Derivatives 2, pp. 60-77, 1995.
Abstract
This paper develops a new strategy for dynamically
hedging mortgage-backed
securities (MBSs). The approach involves estimating the joint distribution
of returns on MBSs and T-note futures, conditional on current
economic conditions. We show that our approach has a simple intuitive
interpretation of forming a hedge ratio by
differentially weighting past pairs of MBS and T-note futures returns.
An out-of-sample hedging exercise is performed for
8%, 9% and 10% GNMAs over the 1990-1994 period for weekly and monthly
return horizons. The dynamic approach is very successful at hedging out
the interest rate risk inherent in all of the GNMAs.
For example, in hedging weekly returns on 10% GNMAs,
our dynamic method reduces the volatility of the GNMA return from 41 to
24 basis points, whereas a static method manages only 29 basis points
of residual volatility.
Moreover, only 1 basis point of the volatility of the
dynamically hedged return can be attributed to risk associated with
U.S. Treasuries, which is in contrast to 14 basis points of interest
rate risk in the statically hedged return.
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Journal of Real Estate Finance and Economics 12, pp. 243-263, 1996.
Abstract
Previous mortgage prepayment and valuation models assume that two
mortgage pools with the same observable characteristics should behave
indistinguishably. However, even pools with apparently identical
characteristics often exhibit markedly different prepayment behavior.
The sources of this heterogeneity may be unobservable, but we can
infer information about a pool from its prepayment behavior over time.
This paper develops a methodology for using this information to
calculate pool-specific mortgage-backed security prices. Knowledge of
these prices is important both for portfolio valuation and for
determining the cheapest pool to deliver when selling mortgage-backed
securities. We find that unobservable heterogeneity between mortgage pools
is statistically significant, and that pool-specific prices,
calculated for a sample of outwardly identical mortgage pools between
1983 and 1989, may differ greatly from any single representative
price.
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(with Jacob Boudoukh, Matt Richardson and Robert Whitelaw)
Review of Financial Studies 10, pp. 405-446, 1997.
Abstract
This paper uses multivariate density estimation (MDE) procedures to
investigate the pricing of mortgage-backed securities (MBS) in a
multifactor interest rate environment. The MDE estimation suggests
that weekly MBS prices from January 1987 to May 1994 can be well
described as a function of the level and slope of the term
structure. We analyze how this function varies across MBSs with
different coupons and investigate the sensitivity of prices to the two
factors. An important finding is that the interest rate level proxies
for the moneyness of the option, the expected level of prepayments,
and the average life of the cash flows, while the term structure slope
controls for the average rate at which these cash flows should be
discounted. Though the origination and prepayment behavior of
mortgages differ substantially across coupons, there remains an
unexplained common factor which explains 80-90% of the remaining
variation of MBS prices. This factor does not seem to be related to
the usual suspects, and therefore presents a puzzle to financial
economists.
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Journal of Finance 52, pp. 1973-2002, 1997.
Abstract
This paper presents a technique for
nonparametrically estimating continuous-time diffusion processes
which are observed at discrete intervals. We illustrate the
methodology by using daily three and six month Treasury Bill data, from
January 1965 to July 1995, to estimate the drift and diffusion of the
short rate, and the market price of interest rate risk. While the
estimated diffusion is similar to that estimated by Chan, Karolyi,
Longstaff and Sanders (1992), there is
evidence of substantial nonlinearity in the drift. This is close to
zero for low and medium interest rates, but mean reversion increases
sharply at higher interest rates.
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(with Nancy Wallace)
Real Estate Economics 26, pp. 173-205, 1998.
Abstract
This paper shows that, in the presence of transaction costs payable by
borrowers on refinancing, it is possible to construct a separating
equilibrium in which borrowers with differing mobility select loans
with different coupon rate/points combinations. We also show that, in
the absence of such costs, no such equilibrium is possible. This
provides a possible explanation for the large menus of mortgages
typically encountered by potential borrowers, and suggests that the
menu of contracts available at the time of origination should be an
important predictor of future prepayment.
We numerically implement such an equilibrium, developing the first
contingent claims mortgage valuation algorithm that can quantify the
effect of self-selection on real contracts in a realistic interest
rate setting. Our algorithm allows investors to account for
self-selection when valuing mortgages and mortgage-backed securities. It
also, for the first time, allows lenders to determine the optimal
points/coupon rate schedule to offer to a specified set of potential
borrowers, given the current level of interest rates.
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(with Nancy Wallace)
Journal of Real Estate Finance and Economics 19, 49 - 67, 1999.
Abstract
This paper analyzes the dynamics of the commonly used indices for
Adjustable Rate Mortgages, and systematically compares the effects of their time
series properties on the interest rate sensitivity of adjustable rate
mortgages. Our ARM valuation methodology allows us
simultaneously to capture the effects of the dynamics of the index,
discrete coupon adjustment, and caps and floors, and can
either calculate an optimal prepayment strategy for mortgage
holders, or use an empirical prepayment function. We find that
the different dynamics of the major ARM indices induce
significant variation in the interest rate sensitivities of loans
based on different indices. We also find that changing assumptions about
contract features, such as loan caps and coupon reset frequency, has a
significant, and in some cases unexpected, impact on our results.
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(with J. Boudoukh, M. Richardson and R. Whitelaw)
in Advanced Fixed Income Valuation Tools, John Wiley, 2000.
Abstract
This chapter presents a non-parametric technique for pricing
and hedging mortgage-backed securities (MBS). The particular
technique used here is called multivariate density estimation (MDE).
We find that MBS prices can be well described as a function of two
interest rate factors; the level and slope of the term structure. The
interest rate level proxies for the moneyness of the prepayment
option, the expected level of prepayments, and the average life of
the MBS cash flows, while the term structure slope controls for the
average rate at which these cash flows should be discounted. We also
illustrate how to hedge the interest rate risk of MBS using our
model. The hedge based on our model compares favorably with existing
methods.
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Journal of Financial Economics 56, 485-516, 2000.
Abstract
The regulations governing asset
distributions from many retirement plans give plan participants the
option to time retirement or rollovers from the plan strategically.
They possess a long-lived put option, whose exercise price resets
periodically to the current value of the assets in the plan. We
derive a recursive closed-form valuation formula for the option, and
develop a numerical algorithm for implementing the result. We find
that, for reasonable assumptions about volatility and life
expectancy, the option's value may approach 40% of the value of the
assets in the plan, financed entirely by those still contributing.
This wealth transfer can, however, be easily avoided by making a
simple change to the current regulations governing valuation and
payout of these retirement plans.
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(with J. Boudoukh, M. Richardson and R. Whitelaw)
Journal of Investment Management 2, 1-6, 2004.
Abstract
The standard VaR approach considers only terminal risk, completely
ignoring the sample path of portfolio values. In reality interim risk
may be critical in a mark-to-market environment. Sharp declines in
value may generate margin calls and affect trading strategies. In
this paper we introduce the notion of MaxVaR, analogous to VaR in
every way except it quantifies the probability of seeing a given loss
on or before the terminal date rather than at the terminal date. Under
standard set of assumptions we provide a simple formula for MaxVaR and
examine the ratio of MaxVaR to VaR. For reasonable parameterizations
MaxVaR may exceed VaR by over 40%. MaxVaR exceeds VaR by as much as
80% or more for high Sharpe Ratio hedge-fund-like sets of portfolio
return distribution.
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(with C. Downing and N. Wallace).
Real Estate Economics 33, 681-710, 2005.
Abstract
This paper develops a two-factor structural mortgage pricing model
in which rational mortgage-holders choose when to prepay and default
in response to changes in both interest rates and house prices. We
estimate the model using comprehensive data on the pool-level
termination rates for Freddie Mac Participation Certificates
issued between 1991 and 2002. The model exhibits a statistically and
economically significant improvement over the nested one-factor
(interest-rate only) model in its ability to match historical prepayment
data. Moreover, the two-factor model produces origination prices
that are significantly closer to those quoted in the TBA market than
the one-factor model. Our results have
important implications for hedging MBS.
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(with J. Berk).
Journal of Finance 62, 529-556, 2007.
Abstract
This paper shows that the existence of managerial ability, combined
with the labor contract prevalent in the industry, implies that the
closed-end fund discount will exhibit many of the primary features
documented in the literature. We evaluate the model's ability to
match the quantitative features of the data, and find that it does
well, although there is some observed behavior that remains to be
explained.
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(with G. Duffee).
forthcoming, Journal of Financial Econometrics.
Abstract
The high persistence of interest rates has important
implications for the preferred method used to estimate term structure
models. We study the finite-sample properties of two standard dynamic
simulation methods---efficient method of moments and indirect
inference---when they are applied to an AR(1) process. For data that
are as persistent as interest rates, the finite-sample properties of
EMM differ dramatically both from their asymptotic properties and from
those of indirect inference and maximum likelihood. EMM produces
larger confidence bounds than indirect inference and maximum
likelihood, yet they are much less likely to contain the true
parameter value. This is primarily because the
population variance of the data (which is extremely sensitive to the
autocorrelation coefficient for persistent data) plays a much larger
role in the moment conditions for EMM than in the moment conditions
for either indirect inference of maximum likelihood. These results
suggest that indirect inference is preferable to EMM when working with
persistent data such as interest rates.
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(with N. Wallace).
forthcoming, Journal of Real Estate Research.
Abstract
Despite the importance of leases in the US economy, and the
existence of several theoretical lease pricing models, there has
been little systematic attempt to estimate these models. This paper
proposes a simple no-arbitrage based lease pricing model, and
estimates it using a large proprietary datset of leases on several
property types. We find sizeable pricing errors that cannot be
explained using interest rates, lease maturity, or information on
the options embedded in the contracts, suggesting the presence of
significant mispricings in the market for real estate leases. We
also propose a new measure, the Option-Adjusted Lease Spread, or
OALS (analogous to an option's implied volatility, or a
mortgage-backed security's Option-Adjusted Spread), that allows
leases with different maturities and contract terms to be compared
on a consistent basis.
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(with M. Cherkes and J. Sagi).
forthcoming, Review of Financial Studies
Abstract
This paper develops a rational, liquidity-based
model of closed-end funds (CEFs) that provides an economic
motivation for the existence of this organizational form: They offer
a means for investors to buy illiquid securities, without facing the
potential costs associated with direct trading and without the
externalities imposed by an open-end fund structure. Our theory
predicts the patterns observed in CEF IPO behavior and the
observed behavior of the CEF discount, which results from a tradeoff
between the liquidity benefits of investing in the CEF and the fees
charged by the fund's managers. In particular, the model explains
why IPOs occur in waves in certain sectors at a time, why
funds are issued at a premium to net asset value (NAV), and why
they later usually trade at a discount. We also conduct an
empirical investigation, which, overall, provides more support for
a liquidity-based model than for an alternative sentiment-based
explanation.
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Abstracts of Working Papers
(with J. Berk and J. Zechner).
Abstract
We derive a firm's optimal capital structure and
managerial compensation contract when employees are averse to
bearing their own human capital risk, while equity holders can
diversify this risk away. In the presence of corporate
taxes, our model delivers optimal debt levels consistent with those
observed in practice. It also makes a number of predictions for the
cross-sectional distribution of firm leverage. Consistent with
existing empirical evidence, it implies persistent idiosyncratic
differences in leverage across firms. An important new empirical
prediction of the model is that, ceteris paribus, firms with more
leverage should pay higher wages.
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(with J. Carpenter and N. Wallace).
Abstract
The cost of executive stock options has become a focus of investor
attention. The difficulty is that option cost depends on the
exercise policies of executives. This paper analyzes the optimal
policy for a general utility-maximizing executive holding a
nontransferable option. We show analytically how the policy varies
with risk aversion, wealth, and dividend rate, and when the policy
is characterized by a single stock price boundary. We also
provide an example with a split continuation region. In CRRA
examples, option value decreases with risk aversion, increases
with wealth, increases with outside hedging opportunities, but can
actually decline with volatility.
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(with C. Downing and N. Wallace).
Abstract
This paper exploits loan-level commercial mortgage data to estimate
loan-by-loan implied volatilities of commercial real estate returns,
using the Titman and Torous (1989) two-factor contingent-claims
mortgage valuation model, and a sample containing all mortgages
appearing in 206 public CMBS deals from 1996 through 2005, a total
of over 14,000 loans. The implied volatility averages about 20-24%
per annum, depending on the liquidity
premium embedded in the mortgage coupon, and show substantial
variation across property types and over time. Using these implied
volatilities, we also compute expected default rates for
representative CMBS pools under realistic assumptions, and find that
the subordination levels for recent vintages of CMBS imply a high
likelihood of default for putatively investment-grade tranches.
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(with M. Rubinstein).
Abstract
The problem of accounting for employee stock options (ESOs) has proven
surprisingly intractable. Rubinstein, in his 1995 article, argues
that the one barrier complicating a clear solution to this problem is
the difficulty of measuring the value of these options. Approaches to
valuing standard listed options do not seem easily transferable due to
the difficulty of measuring volatility and dividends over the long
times-to-expiration, the seeming necessity of forecasting employee
option forfeiture and departure rates, and the effects of
non-transferability on the optimal timing of exercise. However, using
something similar to the service period accounting method discussed
briefly in FASB 123 and advocated recently anew by Bulow and Shoven,
this problem can be overcome. In this paper, we show that the
accounting problem can be reduced to valuing over time a sequence of
short-term options for which these measurement problems become
relatively unimportant. Our solution offers a more general
justification for the service period method than heretofore advanced
and harmonizes accounting in both the post- and pre-vesting periods.
For both periods, only short-term options need be valued. In
particular, for almost all large firms, the market prices of similar
exchange-traded options can be used as objective valuation estimates.
Theoretical considerations and desirable practice can now be combined
in a happy marriage.
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(with J. Boudoukh, M. Richardson and R. Whitelaw).
Abstract
Combining insights from the contingent claims and the asset-backed securities
literatures, we study the economics of value creation in the asset management
business. In particular, we provide a theoretical model and a closed form
formula for the value of fund fees in the presence of the well known flow-performance
relation, giving rise to interesting nonlinearities and volatility-related effects.
The theoretical model sheds light on the role of fees, asset growth, asset
and benchmark volatility, and the intensity of the flow-performance relation.
To better understand the role of changing fund characteristics such as age
and size on the fund value and fund risk, we estimate the empirical relation between
returns and flows conditional on these characteristics for various asset
classes. We study these effects using Monte Carlo simulations for various economically
meaningful parameter values for specific asset classes. Measuring value as
a fraction of assets under management, we find that both value and risk, systematic and idiosyncratic,
decline in size and age. In addition, value is a complex, non-monotonic function of the
fee charged on the fund.
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(with J. Boudoukh, M. Richardson and R. Whitelaw).
Abstract
This paper presents a general, nonlinear version of existing
multifactor models, such as Longstaff and Schwartz (1992). The novel
aspect of our approach is that rather than choosing the model
parameterization out of "thin air", our processes are generated from
the data using approximation methods for multifactor continuous-time
Markov processes. In applying this technique to the short- and
long-end of the term structure for a general two-factor diffusion
process for interest rates, a major finding is that the volatility of
interest rates is increasing in the level of interest rates only
for sharply, upward sloping term structures. In fact, the slope of the
term structure plays a larger role in determining the magnitude of the
diffusion coefficient. As an application, we analyze the model's
implications for term structure pricing, focusing on the conditional
distribution of interest rates and the term structure of term premiums
and volatilities.
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(with Greg Duffee)
Abstract
We study the finite sample properties of some of the
standard techniques used to estimate modern term structure
models. For sample sizes similar to those used in most empirical
work, we reach three surprising conclusions. First, while maximum
likelihood works well for simple models, it produces strongly
biased parameter estimates when the model includes a flexible
specification of the dynamics of interest rate risk. Second,
despite having the same asymptotic efficiency as maximum
likelihood, the small sample performance of Efficient Method of
Moments (a commonly used method for estimating complicated models)
is unacceptable even in the simplest term structure settings.
Third, the linearized Kalman filter is a tractable and reasonably
accurate estimation technique that we recommend in settings where
maximum likelihood is impractical.
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Richard Stanton <stanton@haas.berkeley.edu>
Last modified: Fri Dec 21 21:18:12 Pacific Standard Time 2007