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ILLINOIS (Baa3/BBB-): PENSION REFORM BANNED CH. 9: BANKRUPTCY INEVITABLE

Illinois:

As last outlined in 2017, the State of Illinois is insolvent with shrinking options to avoid filing Ch.9 (the section of the US bankruptcy code available to financially distressed municipalities). Illinois has a population of 12.7mm, making it the 6th most populous state after CA, TX, FL, NY and PA. The Il. population has fallen 6 years in a row as people flee the highest state & local tax burden in the country (yes even higher than the “left” coast CA).

Start here:

https://ibankcoin.com/firehorsecaper/2017/06/06/illinois-gos-baa3bbb-july-fireworks-ahead-junk-sale-likely/#sthash.CjINDlst.dpbs

Without significant public employee pension reform, bankruptcy is a near certainly for the State of Illinois (18 mths – 2 years). As outlined below, pension reforms have been stymied to date, there is no credible case to throw good money after bad in Illinois.

The long required pension reforms are largely common sense; lower payout levels, paid later for those still working, no COLA until 90% funded status is achieved (+3% fixed per annum fixed currently), and gate the defined benefit plan for new workers who will receive comparable support in a defined contribution 401k like plan (like the bulk of the US working population). Pension reform is happening on a broad basis across the country, especially for new public sector employees, but Illinois legacy plans remain sacrosanct.

The average public pension funding level in the US was 70% as we entered 2020. Public pensions garnered positive returns in the last 6 months of 2019 of 6.1%, but have given back approximately 9% in the first 4 months of 2020 (The Year of the Rat, and the Bat bred COVID-19 coronavirus pandemic). The USA country-wide, (i.e. all states) pension shortfall stands at $4.1 trillion. Illinois has a current pension shortfall of $137 billion (against a current pension liability of $214 billion for a 36% “funded status). The rating agencies have acted accordingly, taking Illinois to the precipice of junk at Baa3/BBB- (negative outlook with both). Affordability of retirement programs remains a long terms source of municipal credit stress. Other post-employment benefits (OPEB) account for up to 28% of current unfunded pension liabilities, with the provision of healthcare coverage accounting the the lion’s share. Illinois has never reported their OPEB liability, but is expected to do so from 2020, according to the Governmental Accounting Standards Board. Given the generous public pensions in Illinois, their OPEB liability is 2x the national average on a per capita basis and is largely expected to take their total unfunded pension liability to $210 billion from the current $137 billion (+$73 billion, not “new” by any means, but recognized for the first time).  This level of chicanery might be considered comedic to some, but to me it increased the inevitability of Illinois bankruptcy. Illinois have funded their OPEB liabilities at 0%, with 20 other US states in the same leaky boat.

As noted in my prior write-up municipal bond investors are a conservative lot. 2/3 invest via mutual fund and ETFs, rather than in individual bond issues. Some of these funds have strict investment guidelines to only hold investment grade bonds, leaving the municipal high yield space to specialists in that area.  Little new money is getting put to work in Illinois municipal bonds given the perilous rating, sinkhole pension system, gross mis-management, rampant crime, bottom quartile education system and untenable tax burden at all levels. Most portfolio managers expect Illinois selling pressure as longs seek skinny exit doors on a loss of investment grade ratings.

The City of Chicago situation is even more dire, with the pension plans funded at 23%. The pension underfunding issue is serious in many states, but Illinois is a special case of financial co-morbidity. Illinois incorporated a pension protection clause in their constitution, going forward pension can not be “diminished or impaired”. Illinois pensioners have case law to back them up as well; in May 2015 the State Supreme Court rule unanimously ruled that no cuts to pension are possible, overturning a 2013 pension reform bill which planned to reduce pension costs by upwards of $160bln over 3 decades (i.e. they know what has to be done, but they can not do it, full stop). The other issue that has turbocharged the pension shortfall numbers is a “hard-wired” 3% increase in benefits per annum (this was approved in 19909), having the stand-alone effect of doubling the state pension liability every 25 years. Few will pity those pensioners found in harm’s way when the jig is up. The number of Illinois pensions with payouts > US$100,000 per annum have increased by 74% since 2015. It appears that from a base case of “zero pension” is the only viable starting place for Illinois, and this can only happen with a Ch.9 bankruptcy filing. Taking a quick look in the rear view mirror, in 2008 Illinois was rated Aa2/AA with a pension shortfall of $54.8bln (1.5x bigger in 2020, 12 years later).

Illinois has 5 discrete state pension systems:

Teachers’ Retirement System (TRS). The biggest covering teachers across Illinois (ex Chicago), 130,000 active members, 95,000 retirees (total membership 406,000). The largest pension in Illinois. $122 bln liability, 40% funded 2019.

State Employees Retirement System (SERS). 87,500 members. $47bln liab. 36% funded 2019.

State University Retirement System (SURS). 231,000 members. $42bln liab. 44% funded 2019.

Judges’ Retirement System (JRS). 972 members. $2,7bln liab. 36% funded 2019.

General Assembly Retirement System (GARP). 470 members. 371 million liab. 15% funded.

Illinois Municipal pension plans:

Illinois Municipal Retirement Fund (IMRF). The 2nd largest public pension plan in Illinois. 410,000 members. $44.5bln liab. 90% funded 2019.

Global pension asset stand at $46.7 trillion, approximately 52% of GDP. Asset allocation is fluid, but a snap-shot reflects 45% allocated to equities, 29% to fixed income, 12% to alternative investments and 3% in cash. Low interest rates and higher volatility in risk assets, such as equities, clearly increase the risk profile for public pension.

Global GDP stood at $88 trillion coming into 2020. The negative impact of COVID-19 is estimated to impact global GDP by -5.8 to -8.8 trillion in 2020 (-6.6 to -10% GDP) according to the latest estimates by the ADB this week.

Illinois Debt:

Illinois debt clock; https://www.usdebtclock.org/state-debt-clocks/state-of-illinois-debt-clock.html

With $165 billion of General Obligation (GO) debt and a state GDP of $868 billion (1% of global GDP and 50% of Canada’s GDP), direct debt is optically manageable at 19% of GDP ($13k per resident). The 2nd layer of the onion lays bare the reality that Illinois is an ill-funded pension plan with a small state government attached. Of their annual budget, a full 25% is now consumed by pension servicing (the avg. of all states is 4%). Of the last $10bln contributed to the state pension, $4bln went toward new pension accruals (ARC, actuarially required contributions) and $6bln was expended for servicing. Illinois has issued $25.8bln of pension obligation bonds in aggregate, which are issued as taxable instruments. Illinois has more aggregate pension debt than 41 states. General obligation bonds are tax-exempt with respect to income tax (Federal for all, as well as state and local exempt for Illinois residents). Illinois recently (May 2020) issued $750 million in 2045 maturity GO’s that were 4x oversubscribed. The issue printed at 5.85% yield with reference 10 yr UST yielding 0.652%. With the top federal tax rate at 37% this has a taxable equivalent basis yield of 9.28% (double digit yield for Illinois residents).

The yield on $HYD, the Market Vectors High Yield Muni ETF is 4.64%. $HYG, iShares High Yield Corp Bond ETF yields 5.56% presently ($15bln AUM). The largest investment grade municipal ETF is $MUB with $15bln AUM and it yields 2.39%. The grey-haired investors in muni bonds to date have preferred mutual funds to ETFs, as reflected in their assets under mgmt (AUM). The biggest, Vanguard’s Intermediate Term Tax Exempt Fund has $70bln in AUM, is flat over the last 12 months and yields 2.58%. Nuveen’s High Yield Municipal Bond Fund (18bln AUM) is -9.5% over the last 12 months and yields 5.62%.

Chapter 9:

Municipal bankruptcies are relatively rare. Defaults in the municipal space have largely been restricted to bespoke revenue bonds which rarely affect the upstream, ring-fenced GO issuer. Detroit filed Ch. 9 on 2013 with $18.5bln of debt, the largest default to that point in US municipal finance. Puerto Rico had $70bln of debt in their bankruptcy in 2016 (their pensions were funded in the mid teen’s at the time of tap out, 14% blended).

Illinois will  be a different kettle of fish altogether, much bigger, more complex with more potential knock-on effects. An investment grade rating (just I might add, with a negative outlook by both agencies) is hardly warranted at this juncture and few portfolio managers would buy the credit in the perilous environment we find ourselves. Should Illinois file Ch. 9, the recovery rate would not be stellar (loss given default, LGD) as they have already been to the pawn shop and monetized what they can. Examples include revenue bond secured from everything from toll roads to tobacco settlements. Illinois has even gone so far as to sell their prisons to private operators.

Illinois pensioners might wager that they would be able to secure a higher recovery rate than general unsecured creditors (namely general obligation bond holders) as we saw in the Puerto Rico case, but the degree of “outperformance” might seem moot when GO bond holders get 50¢/$1 and pensioner get 55¢/$1.

COVID-19:

Of the 4,058 COVID-19 deaths reported thus far in Illinois, a full 50% have been nursing home residents. This theme has been prevalent across the country, and the world. Japan’s population is 10x bigger than Illinois at 128 million yet COVID-19 deaths stand at 725 (yes, seven hundred and twenty-five). To have a comparable case fatality rate (CFR) experience, Illinois would have 73 deaths (roughly equiv. to two month of gang violence in Chicago). Japan has an older demographic than any country in the world. Rather than effect a hard lock-down, Japan has chosen a “cluster” C-19 treatment approach. Some credit has been given to universal BGC vaccinations (for TB) and that the COVID19 strain in evident in Asia appears less virulent, but all remain perplexed at the marked CFR discrepancies between countries. Notably, rates of obesity in Japan are 4.3% versus 36% for the USA and in the “at risk” demographic of 65+ I would argue the obesity rates in Japan are below the 4% average. I’m not a Doctor, this will be a subject of great debate and study as well navigate the “new normal” in 2H 2020 and beyond.

Illinois residents, save essential services,  have been largely home bound since March  7th (Shelter-in-place order remains in effect). Government spending, esp. for healthcare have skyrocketed while sale tax revenue have plummeted (state income taxes to follow). Illinois, via Senate President Don Harmon has requested a $41.6 billion bail-out from the federal government (largest items include $14bln to close the state revenue shortfall, $9.6bln to aid Illinois cities, $6bln for the unemployment trust fund aid and $10bln for “kick the can”pension servicing.

Pictured: Illinois Governor Pritzker continues to press that the Illinois remain effectively closed until the novel coronavirus is all but defeated (BMI undisclosed, seems high).

Senator Majority Leader Mitch McConnell has been vocal in pushing for the bankruptcy route for failing states, rather than kitchen sinking state pension bail-out in future COVID-19 relief bills. Mitch’s home state of Kentucky makes Illinois look financially prudent with the worst funded pension of the contiguous states with a laughable 16% funded rate. Kentucky is gracefully a small state in terms of significance and the unfunded pension liability is $36bln in absolute terms, a paltry 26% of Illinois $137bln shortfall (Puerto Rico was blended at about 14% across their 4 plans when they tapped out, for reference).

Public sector employment in the US averages 14.5% (State & local government employs 20 million in the USA). The 30 million currently filing for unemployment claims are largely from the private sector with a heavy weighting in the  food & beverage, entertainment, transport and hotel sectors. None of the hundreds of thousands of Illinois public sector workers have been furloughed and the pension benefits continue to grow at a factor of 1.03 per annum.

14% or 1.8 million Illinois residents collected food stamps in 2019.

The latest government largess proposal, the $3 trillion HEROS Act, approved by the House of Representative last week, includes sweeping support for a pension plan bail-out via Division D, Title I, the Emergency Pension Plan Relief Act of 2020 (there are no benefit cuts proposed in the formula, big surprise). There are very long odds on this bill garnering broader support in its current form (as in ZEROS, a more appropriate bill name than the flag-wrapped swill the lobby groups try to pass off as 1st growth wine).

The Federal Reserve balance sheet has gone from $2.7 trillion to $7 trillion with remarkable speed (quantitative tightening to quantitative easing infinity). Monetary policy (short rates) went from the early innings of a tightening cycle in late 2019 (2.25% Fed funds) to zero inside of 6 months. Unemployment went from record lows (full employment) to 15% (20% + if fully reported) over the same time sub 6 month period.

Conclusion:

Is is premature to think we are “out of the woods” and the global municipal finance implications have not been fully vetted , let alone understood and absorbed. Those modeling “cliff risk” should have a delta of > 0.7 assigned to a State of Illinois default on an 18 month timeframe. EM will have more than enough fireworks as well, but I see Illinois as the “big 1” in the US municipal market. China’s lack of access to USD swap lines mean that devaluing the Yuan ($CNY) is their only near term course of action. The word for 2021 in global municipal finance will be austerity. MMT is poppycock. The near term demon to be slain is deflation. The only trade I like for more than 5 trading days is short the € versus the USD.

There is not enough yield pick up to venture into IG (taxable or tax-exempt), let alone HY, even with the goosing the Fed has effected with their announced and recently under taken HY ETF purchase program. A municipal credit support program is in the works, 100%. The last highly effective program for munis was the Build America Bond (BAB) program which, while limited in size and tenure ($147bln 2008-2012), the program had the desired effect of bringing in muni credit spreads, flattening the muni credit curve and providing funding to liquidity starved sectors of the muni market (healthcare/acute care in particular). The follow-on program linked to an infrastructure build out, America Fast Forward (AFF) never came to fruition, but most, including the writer, believe that infrastructure will be the next and on-going focus.

Trade safely. Cash is a viable investment alternative.

Follow me on twitter @firehorsecaper

Regards,

Caleb Gibbons, CFA, FRM

 

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ESG : SOCIAL INVESTING = INVESTING

Even the Asian elephant in the room is endangered.

Over 80% of the market value in the S&P is attributable to intangible factors (environmental capital, sustainability governance and stakeholder relationships). Less than 20% is accounted for by physical and financial assets.

Global sustainable investing assets grew by 61% over the 2012-2104 period and now stand at $21.4 trillion. The domicile of these assets is telling; 99% are in the United States, Canada and Europe.

Environmental and social issues affect both valuation and financial performance. If your investment decisions focus only on financial disclosures, you will not be getting a complete picture of the drivers of value.

Global ethical principles have never been more important or, it appears, more wanting than in current times (i.e. VW, Phoney Express aka Well Fargo, global Trumpism, and global lawsuits imperiling not just returns but the very viability of global commerce beyond national borders).

Community manager education world tree concept with colorful abstract leaves and earth icon illustration. EPS10 vector file organized in layers for easy editing.

The UN supported Principles for Responsible Investment (PRI) ,a not-for-profit organization, held their 10th anniversary conference in Singapore last week (Sept. 6-8th) which I attended. No conference bag full of binders and junk mail at this conference, your 1 page agenda fold up into your name tag and all meals were vegetarian, a subtle but effective message. Forbes Magazine The conference domicile was not chosen by chance. Asia has been termed the cradle of disorder for a reason, it is home to 5 of the world’s 7 billion population and on metrics of social investing if the game has even started it is is the 1st inning. When a region has practices like dynamite fishing and farmers still clear land with a match much work lies ahead.

Chris Sanderson, Co-Founder of The Future Laboratory focussed largely on the sustainability of the capital markets. He characterized global citizens as being tired of austerity, wary of politicians and perhaps even more wary of brands. Backlash culture; http://shop.thefuturelaboratory.com/products/backlash-brands-report.

Elliott Harris, Head of the United Nations Environmental Program (UNEP) gave a rousing speech on environmental and social sustainability. The end game is that all investments will be social. Elliott introduced the concept of thick profit versus thin profit, a concept akin to quality, hard to define, but you know it when you see it.

Georg Kell of Arabesque Partners Arabesque spoke of  Generation S, a cross-section of all age groups working towards making the world a better place, one worthy of handing down to future generations. While ESG (environmental, social & governance) alpha may prove illusory, ESG smart beta appears to have legs.

Millennials were of course discussed with the most shocking realization being that the oldest ones (born 1990) are in their mid 30’s now! Generation D (Digital), whose only need or want in life is wifi and lithium, was out in full force, albeit well behaved and overall attentive. The 600 conference attendees were largely baby boomers, representing approx. 50% of global financial assets under management (AUM), signatories to the PRI whose mission states, “We believe that an economically efficient, sustainable global financial system is a necessity for long term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.” Clear, concise, devoid of the typically mumbo jumbo one gets when issues like climate change and the environment are normally tabled.

The session run by GS alum David Blood, Managing Partner at Generation Asset Management Generation Investment Management was excellent. Al Gore is the Chairman of Generation Investment Management. If Obama delays the election to allow Clinton to get her legs perhaps they could run as a Third Party choice? Could not lose with the ticket “Blood & Gore”. Both men can readily point out Aleppo on a map too. In any event, David’s sage words rang true to all in attendance. Finance and capitalism is not working for everybody was a key statement. The transition to a low carbon economy will clearly not be an easy one. A full 1/3 of aggregate world equity and fixed income market value lies in the cross hairs. We can do this the hard way or the easy way, but de-carbonization is a trend now moving under its own power. Mr. Blood noted that while the majority of global asset managers in attendance (120 signatories, 50% of global AUM) were managing to sustainability factors, those not present (i.e. non PRI Signatories) are largely American. The reasoning to date for USA firms reluctance is that becoming signatory could put them in breach of their fiduciary duty. We must collectively get the remaining 50% on board as priority #1.

esg-programs-11

Investing for the long term. Short termism. A great panel on investing for the long term had some serious panel power. The headliner was Hiro Mizuno, CIO of Government Pension Investment Fund, Japan (GPIF), the world’s largest funded pension plan. GPIF manage their liabilities to a 100 year time frame. Their most recent result showed a loss of ¥5.3tln (US$5.2bln) for the current fiscal year through March 2016. The fund’s quarterly loss through June 30, 2016 was > ¥5tln (-3.88%). They run ¥130 trillion (US$1.27 trillion) leading Mizuno-san to characterize the latest qtly loss as peanuts. The joke was not well received, perhaps because it was so unexpected, leading Hiro to quip that perhaps there were Japanese pensioners in the audience. The fund increased their allocation to equities in recent years. Global equity investment totals US$600bln, 80% of which is allocated in a passive fashion and 20% ($120bln) of which is actively managed. All investment are mandated to external manager, counter to the global trend in the pension arena of in-sourcing. Fellow panelist Paul Smith, President & CEO at the CFA Institute noted that one advantage of being old is that “you see everything twice” with such decisions as out-sourcing vs. in-sourcing set to very long term market cycles.

Several panels touch on infrastructure finance with GPIF mentioning their joint investment effort with Canada’s CPP on ESG brownfield infra projects. Mizuno-san noted the challenges of crafting/originating greenfield projects as funding challenges often drive the cheap option and the cheap option is usually dirty (materials, supply chain, etc.). GPIF will not finance dirty deals, full stop.

A deeper discussion ensued on better was to measure and compensate performance with a general aversion shown to managing to qtly earnings guidance. The average hold period for SPY, the > $100bln S&P 500 SPDR, the largest ETF tracking the benchmark for US stocks is 5 days. In the last 15 years 52% of the Fortune 500 companies as no longer in existence. In 1955 the average Fortune 500 company life expectancy was 55 years, in 2015 it is 15 years. Traditional valuation metrics clearly must evolve to address the realities.

ESG toolkit for Fund Managers: http://toolkit.cdcgroup.com/

Q&A with Author of the PRI’s Practical Guide to ESG Integration for Equity Investing

The ESG investment construct must be turned on its head, to my mind. Social investing = investing and “dirty” or non-socially minded investment should be the type requiring explicit sponsor/board/member approval. JCG

Follow me on twitter @firehorsecaper

shenzhen-beach

Shenzhen “beach” September 2016

Mark Carney, Chair, Financial Stability Board (FSB). Awesome 30 minutes of your life, watch it. Carnage, indeed.

 

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$CXW, $GEO REIT – DOJ THROWS AWAY THE KEY ON PRIVATE PRISONS

Yates_private prisons

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Investors in listed private pension companies Corrections Corporation  of America (CXW), and The GEO Group, Inc. (GEO), got murdered yesterday. $CXW fell nearly $10 to close $17.57 (mkt cap $2.1bln), down 35% on the day, with $GEO closing down 40% to $19.50 (the smaller of the two, mkt cap $1.44bln).

Most articles published since that I have read focus on the morality issues, but IBC readers have their own steady compass on that front, the Peanut Gallery is here to guide your investment thinking and analysis when tape bombs like Deputy Attorney General Sally Yates memorandum to the Bureau of Prisons (BOP) hit the wire (link to actual letter at top of post). Amazon’s Washington Post broke the story that stated the US Justice Department plans to end the use of private prisons.

This is a big deal and should not be discounted as a driver of the valuation of these companies going forward. The Democrats have had this issue on their radar for some time. Obama has been keen to push reforms of the criminal justice system in the US, acknowledging the fact that the US incarcerates too many,almost 0.7% of the entire population (the “1%” nobody likes to talk or think about) with an undue weighting of African-American inmates (2.7% versus 0.5% for other races). It is clearly too late for “Obamabars” or whatever catchy reform slogan they might come up with, but Hillary is clearly ready to take the baton and she is not likely to miss the hand off. In her well publicized tweet of November 2015 Hillary tweeted, “We need to end private prisons.” The aforementioned prison outsourcing stocks were down 4-6% of the day of the tweet, but bounced back in the absence of immediate follow up. Enter Sally Yates.

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The typical legacy contracts which granted private prison operators 20 year terms with 90% occupancy will be no more. More lucrative deal which were negotiated on a “set price” basis, irrespective of occupancy levels, will likely be re-negotiated.

The Bureau of Prisons (BOP) contracts for Federal prisons and have traditionally have up approximately 1/2 of the revenues for both $CXW and $GEO. State and Municipal contracts make up the remainder and while BOP’s directive will have sway going forward, the pace of contract roll-off will likely be measured due to tight budgets.

While only 8% of Federal prisoners are housed in private prisons, 62% of immigration detainees are housed in private facilities. Immigration & Customs Enforcement (ICE), a division of the Department of Homeland Security (DHS) are the ones that contract for immigration detainees. Immigration offenses now exceed drug offenses in absolute number and full 1/3 of all Federal criminal cases are immigration related.

Politicians, regardless of level of government, do not like having things blow up in their faces. When the US already spends 6x more on prisons than on education, cost containment will be key as BOP figure out the optimal way to respond to the clear DOJ directive (a 5 year run-off period has been assumed).

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Private prisons are officially in the “sin” category along with tobacco, liquor, and casinos.

What to do. My focus will be on $CXW; Correction Corporation of America. For those, like myself, without current exposure to either name this is a time for study and analysis.

Brave analysts to comment thus far appear to be in the buy the dip (BTD) camp and appear to have a modest preference for $GEO over $CXW, speaking to the listed equity. Looking at the capital structure, $GEO has more debt, $2.23bln with Senior secured rated Ba3 and Senior Unsecured rated B1. CXW was upgraded by Moody’s to Baa3 in June 2015 and has $1.4bln in debt.

CXR 4.625% May 2023’s were not immune from the carnage of yesterday’s trade, falling from $102 to $85.50 (-16.2%) on the day. My expectation would be for the equity to rebound from the current levels and for the bonds to drift lower concurrently. The catalyst for a sharper move in the debt would be loss of investment grade rating by Moody’s. Assuming the debt is taken back (i.e. downgraded) to Ba2 (speculative grade) from investment grade there may be an opportunity to buy the debt ($70.00ish) on a hedged basis, shorting $CXR equity to the expected recovery rate on the bonds. As this opportunity unfolds, I would expect there would be cuts to the dividend on the common shares which would reduce the negative carry on the hedge.

The closest proxy I could come up with in analyzing private pension debt is military housing debt. To be clear, no analogy is to be drawn between criminals and brave service men and women that protect the nation, this is purely an asset valuation exercise. A large portion of the USA’s military housing has been privatized. The debt issued is not municipal debt, an important distinction, but is supported by the “Basic Allowance for Housing” (BAH) that is earmarked annually as an appropriation from the Federal budget by the Department of Defense (DOD), the world’s largest employer. On balance, the location of the private military housing complexes is favorable (something to think about as bases get slated for closure on occasion) to private prisons. Military housing has a much better alternate use as well, including civilian use and/or re-purposing.

The fix is in, it would appear. Private prisons will be as popular as a coal seam in the Appalachians. Trade accordingly. JCG

 

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