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Doing Borrowed Time: The High Cost of Back-Door Prison Finance
Declining public enthusiasm for costly prison expansion plans has closed off traditional options for financing new prison construction. But this trend has created new opportunities for a cottage industry of investment bankers, architects, building contractors, and consultants to reap large rewards with “back-door” financing schemes. A review of recent prison, jail, and detention expansion initiatives shows that federal, state, and local governments are using back-door financing mechanisms to borrow hundreds of millions of dollars to build facilities that the public does not want and cannot afford.
Paying For Prisons—?Corrections Takes The “Public” ?Out of Public Finance
Until the mid-1980s, prisons were generally built in one of two ways. State officials either took the “pay-as-you-go” approach by funding new construction out of general revenues; or they borrowed money through the sale of general obligation (GO) bonds.1 A general obligation bond is an unlimited repayment pledge that is backed by the “full faith and credit” – including the taxing power – of the issuer. Failure to pay debt service on a general obligation is rare among large government entities and is tantamount to bankruptcy. The issuance of new general obligation bonds often requires approval by taxpayers in the form of a bond referendum.
As correctional populations and costs mounted in the 1980s and 1990s, states had greater difficulty funding expansion out of their operating budgets or winning public approval for new debt. State officials responded to these developments by issuing another type of debt – revenue bonds – to finance new prison construction.
Revenue bonds are limited obligations that are backed only by assets and income streams specified in the issuing documents. Revenue bonds were originally designed to provide a source of financing for projects that could generate sufficient revenues to pay for themselves over time. The classic example is a bridge that generates enough income from tolls to cover the cost of operations, upkeep and debt service on the bonds issued to finance its construction. Revenue bonds can be issued without public approval because they are not backed by the full faith and credit of the government.
Prisons, jails and detention centers would seem to be poor candidates for revenue bond financing since they are largely or entirely funded with tax dollars. Yet in 1980, Gov. Mario Cuomo responded to voters’ rejection of a $500 million prison bond referendum by turning to the state’s Urban Development Corporation (UDC).
The UDC is a nonprofit corporation established after the assassination of Martin Luther King, Jr. to expand access to affordable housing. The Governor used the UDC to issue revenue bonds to build upstate prisons – a very different kind of low-income housing. The “revenues” backing the bonds came from leases between the UDC and the state’s Department of Correctional Services.
Under such lease-revenue arrangements, the state has no legal obligation to repay the debt incurred by its bonding authority, and the legislature can terminate the lease at any time by choosing not to appropriate the necessary funds. Revenue bond financing allows officials to dispense with restrictions on general obligation debt such as constitutional debt limits and public referenda requirements.
Behind the legal fiction, however, is a “moral obligation” to investors who purchased the bonds. The consequences of failing to meet such a “moral obligation” can be as serious as the consequences of failing to meet a legal obligation. They range from a costly “downgrade” of a state’s bond rating to reluctance of investors to make further investments in the region.
Revenue bonds and other back-door financing schemes became more popular during the 1990s when state officials found themselves squeezed by mounting corrections costs and a growing anti-tax chorus. The website PublicBonds.org reports that, by 1996, more than half of new prison debt was being issued in the form of certificates of participation, a type of lease-revenue bond.
Some local governments continue to issue general obligation debt to finance jail expansion. But no state has built a new prison with general obligation bonds since the turn of the century and few have put the question to voters. It’s not hard to figure out why. A 2002 proposal to build a $25 million new prison in Maine was defeated by a two-to-one margin, while California Gov. Arnold Schwarzenegger was recently forced to pull a $2.6 billion prison proposal from a bond package after failing to find support for the measure within his own party.
Instead, states pursuing a prison expansion agenda have done so through increasingly complex, and costly, back-door finance schemes. State officials are not alone: back-door financing is playing an increasingly important role in prison and jail expansion at the federal and local level, as well as in the private sector.
Officials in Shelby County, which includes the city of Memphis, Tennessee, were recently courted by the nation’s leading private prison companies with offers to build a massive new jail. A plan advanced by The Geo Group (formerly Wackenhut Corrections) would have established a nonprofit bonding authority to issue revenue bonds, while Corrections Corporation of America offered to build the facility using its own credit line in exchange for a 50-year lease agreement. In 2005, CCA made a similar proposal to the leaders of Richmond, Virginia.
Even private prison companies, which can serve as vehicles for back-door prison financing, are themselves seeking ways to keep prison debt off their books and to push risk back onto the public sector. Several have sought to finance new prisons through, or sell existing prisons to, local economic development authorities and then lease the facilities back. Such arrangements not only give private prison companies access to low-interest, tax-free financing, but also allow them to avoid becoming saddled with costly, vacant real estate if a contract is terminated. Correctional Services Corporation, for example, sold several facilities to local bonding authorities before being acquired by The Geo Group in July of 2005.
Finally, the process employed by U.S. Marshal Service (USMS) and the Department of Homeland Security’s Bureau of Immigration and Customs Enforcement (ICE) to secure detention beds has encouraged speculative detention growth. Less than a quarter of USMS detainees are housed in federal facilities according to statistics published by the Office of Detention Trustee, which manages federal detention contracts. The rest are housed in state, local or privately-owned facilities under contracts and Inter-Governmental Agreements. The promise of profitable federal immigration detention business has spurred counties in Texas and elsewhere to “super-size” their jails and build new facilities solely intended to serve the federal detention market.
Cost #1- Policymakers Binge On Easy Prison Credit
Easy access to investment capital permits policymakers to commit to thousands of new prison beds that will cost billions of dollars to operate over the coming decades while putting, as they say in the car commercials, “nothing down.” The lucrative nature of back-door prison finance deals also brings together set of powerful financial interests which have a large stake in pushing the deals through.
North Carolina has financed construction of five prisons since 2001 by engaging a private consortium to float bonds, build facilities, and sell them to a state bonding authority. The North Carolina Infrastructure Finance Corporation then issued its own bonds to finance the purchase of the prisons for the state. The deals generated millions of dollars in fees for developer Carolina Corrections and the investment bankers at Lehman Brothers who sold both sets of bonds.
A few years ago, Arizona found itself caught between a rapidly growing prison population and record budget deficits. Lawmakers responded by turning the bulk of new prison finance over to the private sector. Private prison companies have arranged financing for 2,400 new beds that operate under long-term contracts with the state over the past half-decade, while the state has built 1,000 new public beds using proceeds from the sale of lease-revenue bonds.
Back-door financing arrangements drive up the long-term costs of prison expansion. Complex deals require more work from investment bankers and attorneys than straightforward state bond sales. Outsourcing also increases the risk to investors who demand higher rates of return and/or costly bond insurance.
But such schemes provide short-term benefits to elected officials. Back-door financing keep prison debt “off the books,” avoiding constitutional caps, and concealing major long-term obligations from normal budget scrutiny. Decisions about prison expansion remain beyond the reach of the voters who will bear the costs of operating them. Finally, back-door financing generate large transaction fees for investment bankers and others with deep pockets and close ties to state officials.
Back-door prison financing encourages overbuilding and has a corrosive effect on criminal justice policymaking. In both Arizona and North Carolina, bipartisan groups of legislators were considering sentencing reform proposals that could have reduced or eliminated the need for prison expansion. Given the intense budget pressures each state faced and the lack of public support for further prison spending, reform seemed to be the obvious choice. But once big-ticket expansion plans gathered momentum, advocates of sentencing reform had difficulty getting a serious hearing for their ideas.
A perverse loophole in the law has pushed officials in one Texas county to overbuild a jail in order to secure financing. In 2004, Willacy County was being pressured by the Texas Commission on Jail Standards to fix persistent problems with plumbing and overcrowding of female detainees in its 45-bed jail. The county was in a quandary. A budget crisis had forced local officials to borrow $1.5 million for operations, pushing the county’s debt load and tax rates to the maximum allowed by law – 80 cents per $100 of assessed property valuation. Unable to issue county obligation bonds to finance a new jail, officials faced the unappetizing prospect of being shut down by TCJS and spending millions of dollars to transport detainees and house them elsewhere.
They chose another option that might at first seem counterintuitive – borrow two or three times as much money, at a higher interest rate, to build a jail twice the size needed. The larger jail could then be marketed to the federal government and, as the county’s investment banker put it, be “paid for by the inmate population at no cost to the taxpayer”.
County Judge Simon Salinas considered the scheme’s chances of success to be slim. With no other means to bring the jail up to state standards, however, local officials decided to take the gamble. The new jail was built, but the detainees did not come. In May of 2006, the county was forced to pay bondholders $137,000 out of its general funds and commissioners reported that the county risked losing control of the facility.
Cost #2- Back-Door Finance Locks In Excess Prison Capacity
State policymakers know only too well that pressure from local communities and other interested parties makes prisons easier to open than to close. Reginald Wilkinson, who until recently ran Ohio’s Department of Rehabilitation and Corrections, had to go all the way to the Ohio Supreme Court to vindicate the department’s right to close prisons over the opposition of the prison guards’ union.
But closing a prison, jail, or detention center can be doubly difficult if the facility was financed “off the books.” Louisiana lawmakers discovered this unfortunate fact when they tried to shut down the nation’s most notorious juvenile detention center.
In 1995, the Louisiana Department of Corrections entered into a “cooperative endeavor agreement” 2 with the City of Tallulah and Trans-American Development Associates (TADA), a group of businessmen with close ties to then-Governor Edwin Edwards, for the construction, financing and operation of a secure juvenile facility.3 Swanson Correctional Center for Youth - Madison Parish Unit, better known as the “Tallulah” facility, was financed and then refinanced with bonds backed by the state’s operating contract with TADA.
Tallulah became notorious for abusive conditions, and the problems did not end when the state took over operating the facility. But state legislators who wished to withdraw funding for the facility – including $3.2 million in annual payments to the owners for debt service – were hamstrung in their efforts. State officials received letters from rating agency Standard & Poor’s and bond insurer Ambac warning that a decision to break the juvenile prison lease could damage the state’s bond rating.
The state could simply have shut down the Tallulah facility while continuing to make lease payments. But such a move would have put lawmakers in the politically unpalatable position of appropriating millions of tax dollars each year for an empty prison (a step that lawmakers were eventually forced to take anyway). Youth confined at Tallulah were left to suffer for another year while the bond controversy delayed closure of the facility. When lawmakers did act, the bill to close Tallulah came attached with a rider requiring the state to reopen it as an adult prison.
If the construction of Tallulah’s youth prison had been financed out of the state’s capital budget, it would have been a simple matter to convert the site into a learning center, a demand made by local residents, or abandon it entirely. The state would still have been obligated to repay the debt incurred to build the facility, but the payments would be smaller – courtesy of cheaper public financing – and buried in the tens of millions of dollars spent each year to service state debt. Lawmakers instead found themselves trapped in a costly lease that could not be terminated without damaging consequences to the state’s credit rating, for a prison that must be kept filled in order to justify the lease payments to voters.
Arizona officials have entered into similar arrangements, signing off on the sale of $132 million in private prison bonds backed entirely by state lease payments since 2000. Even if bond rating agencies and insurers were willing to let Arizona out of the leases, fear of a damaging default could prevent the state from canceling contracts with private prison operators. Most of Arizona’s state-contracted private prisons have been financed or refinanced with bonds issued by county industrial development authorities. The bonds are not legally county obligations, but a default could still scare away investors and raise the cost of borrowing for both public and private groups in the region.
Cost #3- Immigrant “Gold Rush” Creates Speculative Detention Bubble
The emergence of prison and detention markets and easy access to investment capital have combined to create the conditions for speculative expansion, especially at the local level. No state has seen more speculative prison growth – or more fallout from speculation – than Texas. The state made headlines in the early 1990s when a detention scheme promoted by a group of investment bankers and developers collapsed resulting in one of the largest-ever bond fraud and conspiracy cases.
A decade later, Texas’ speculative detention market is hotter than ever thanks to a federal detention “gold rush.” One group of investment bankers has played a particularly active role – helping to inflate the detention bubble by setting up a string of questionable deals that span the state. Over a five-year period, a Connecticut bond house known for putting together “tough” deals and a Dallas firm with substantial experience financing private prisons sold nearly $200 million of revenue bonds for eight rural Texas counties and one small city.
The proceeds of the bond deals underwritten by Herbert J. Sims & Co. and Municipal Capital Markets Group were used by the sparsely-populated localities to build, acquire or refinance for-profit jails and detention centers that derive the bulk of their income from housing federal detainees or other states’ prisoners. The team’s first Texas deal financed construction of a speculative detention center in the Texas Panhandle that has faced financial problems and allegations of abuse. The second transferred ownership of an existing private prison to the host county and loaded the facility with $13 million worth of debt.
The team’s fourth Texas detention deal landed the underwriters and their partners in the pages of The Bond Buyer. On November 7, 2002, the La Salle County Public Facilities Detention Corporation issued $21.9 million of taxable revenue bonds to fund construction of a 500-bed detention center for U.S. Marshal Service (USMS) detainees whose cases were being heard in nearby Laredo.
The project gave many causes for concern. The county had an Inter-Governmental Agreement with USMS for the use of the facility, but no firm commitment of how many beds the agency planned to use or for how long. The county’s partner in the project, Emerald Correctional Management, had very little experience in private corrections. La Salle’s top elected official had been barred from doing business with the Department of Housing and Urban Development for misuse of low-income housing funds. Finally, the deal featured generous financial terms – including 12-percent interest rates and large payouts for those who put the deal together – that benefited everyone but taxpayers.
Opponents of the project won a major victory when County Treasurer Joel Rodriguez, who had voiced serious concerns about the enterprise, defeated incumbent County Judge Jimmy Patterson in the Democratic primary. Patterson and his allies responded by pushing the bond deal through over the objections of County Attorney Elizabeth Martinez. When Martinez refused to sign an opinion drafted for her by outside counsel, the opinion was simply included without her signature among the bond documents.
The sale of the bonds generated $1.3 million in underwriting fees for Sims and MCMG, along with a $700,000 consulting fee for ex-Webb County Commissioner Richard Reyes.
Local officials were forced to defend and eventually settle a lawsuit filed by local residents Donna Lednicky and Sean Chadwell under the state’s Open Meetings Law.
Meanwhile, payment of a USMS Cooperative Agreement Program grant that was critical to financing the facility was delayed by an environmental lawsuit which rancher Greg Springer filed against the law enforcement agency. The county was ultimately forced to issue an additional $5.45 million in bonds due to cover the delays and cost overruns.
The La Salle bond sale was followed quickly by two more controversial transactions. In January 2003, officials in nearby Crystal City borrowed $14 million to finance a $9 million purchase of an existing private detention center whose assessed value was just $6 million. The sale generated protests by local residents, but also large payouts to bond underwriters, the city, its public finance corporation, and a consultant.
A July 29, 2003 article in The Bond Buyer warned that experts believed a wave of Southwest detention deals posed “a growing risk to bondholders and the counties that stand behind the projects”. Two weeks later, Hudspeth County officials borrowed $23.5 million through a public finance corporation to build a 500-bed speculative detention center 90 miles from El Paso. Local residents questioned the project’s feasibility and sued unsuccessfully to block the bond sale. Business slowed somewhat after 2003. But Sims and MCMG continued to execute detention deals, including a $24.22 million revenue bond issue to fund construction of a jail in Polk County; and a $31.41 million revenue bond refinancing for Garza County.
The rapid growth of local detention finance schemes is a recipe for disaster. The most telling failure may be the near-default of a 3,000-bed, $90 million detention project in Reeves County. Reeves was one of a few detention center projects whose bonds could secure an investment-grade rating because of what was considered an effective management team, a strong client relationship with the Federal Bureau of Prisons (BOP) and growing demand for contract beds in the area.
Then in late 2003, the detention center suddenly found itself on the brink of default after the BOP declined to sign a contract for 1,000 new beds that had been added to the facility. The county was ultimately forced into the arms of The Geo Group which took over bond payments and management of the project. Reeves’ sudden reversal of fortune caught analysts by surprise, and revealed how little those charged with the “self-regulation” of public debt know about the detention market.
Why The Economics of Prison Expansion Escape The Bond Markets
The current wave of prison expansion is financially unsound. Public enthusiasm for incarceration has waned and it is plausible that long-term demand for beds could fall below the current supply. The federal appetite for new prison and detention beds continues unabated, but lawmakers have not yet shown a willingness to fund them at a level that would take up the slack in the much larger state prison market.
These developments may not be of great concern to investment bankers and bond counsel, who make money on both good and bad deals. They should be of great concern to bond investors, who risk losing their shirts if supply greatly exceeds demand. Yet investors seem blissfully ignorant of the dangers. Their failure to appreciate the risks of long-term investments in prison expansion may be rooted in the differences between prisons and other bond-financed projects.
The bulk of municipal bonds are issued to fund projects such as sewer and water systems, highways and schools that meet public needs in a direct and obvious way. Most people flush toilets, drive to work and send their kids to school on a daily basis. Consumers of these services may argue over what the quality should be and how much they should pay for them. But it’s safe to assume that they will keep paying as long as there is money in the bank.
It is more difficult to determine how many prison beds the public needs and is willing to pay for. Researchers have found little correlation between incarceration and measures of public safety such as crime rates, and to the degree that a relationship exists, it doesn’t necessarily go in the right direction. Opinion research has shown that the public is deeply ambivalent about the wisdom of current high incarceration rates and reluctant to throw more money into a system that delivers such poor results.
But bond investors are getting all of their information from bond issuers who have a financial stake in making prison bonds look as safe as possible. Prison bond documents are full of information about the remarkable pace of prison population growth over the past quarter-century. They contain little or no information about sentencing and correctional policy reforms, shifts in public opinion or other trends that would weaken the case for new prisons.
If investors knew that modest sentencing and correctional policy reforms could pull the floor out from under prison population growth in Arizona, they might think twice about buying private prison bonds issued by the Pinal County Industrial Development Authority. If financial analysts understood the extent of speculative detention growth in Texas, they might have been less sanguine about the prospects for a major bed expansion at Reeves.
The risks back-door prison finance poses to both investors and governments are very real. A review by staff at Good Jobs First, a nonprofit economic development think-tank, found that prisons financed with certificates of participation accounted for a third of all lease-backed bond defaults in the 1990s. A decade ago, a $74 million speculative scheme to build 500-bed prisons in six Texas counties collapsed when five of the six were unable to house the necessary numbers of prisoners. The fiasco gave rise to one of the largest-ever bond fraud and conspiracy cases and resulted in a partial bailout by the state which acquired sub-standard jails at 50 cents on the dollar.
More recently, the bond ratings of three Texas counties – Hayes, Hood and Kerr – were downgraded after local officials decided to walk away from lease-purchase agreements. Hayes County built a juvenile detention center twice the size it needed with the intention of renting the remaining beds to other counties. But Texson Management Group, which set up the deal, went bankrupt and left the county holding the bag. In 2003, Standard & Poor’s downgraded Hayes County’s bond rating from A-plus to BBB-minus based on the county’s failure to meet its “moral obligation” to repay the debt. Crystal City has already been denied a loan to buy trucks and police cars because of concerns the city’s detention deal raised for a local bank.
Build It and They Will Come (But Not In Time to Pay the Mortgage)
The belief that prison expansion is inevitable could become a self-fulfilling prophecy, at least in part. Once prisons, jails and detention centers are built, the political pressure to fill them is enormous. Back-door financing only heightens these pressures by aligning bond investors, insurers and rating agencies with the communities that see prisons as a source of jobs and economic development.
This is not to say that new prisons will be a sure bet for investors or local governments that engage in back-door finance schemes. The lack of rational planning processes virtually guarantees that there will be slippage between the supply and demand for prison and detention beds.
The best financed, informed and connected market players will be able to survive the slippage and even thrive on it – picking up valuable prison real estate at rock-bottom prices. Meanwhile less well-positioned counties and investors will fall through the cracks when they make bad market bets or simply get squeezed out by more powerful competitors. Worst of all, long after their bonds have gone into default, with damaging consequences to local economies, the prisons will still be there demanding to be filled – with immigrants, kids, the mentally ill, or another population du jour.
The bigger question for the financial markets is not why they turn a blind eye to risky prison financing deals but why they don’t pay more attention to the broader implications of growth in the use of incarceration. Prisons are a drop in the public finance bucket, but the cost of operating prisons and jails makes up a significant and growing share of state and local spending.
According to the most recent available figures, for every dollar spent on state prison construction, $16 was spent on operations.4 The hundreds of millions of dollars that are being borrowed for back-door state prison expansion will draw down billions of dollars in operating costs, draining states of the resources needed for services that strengthen their long-term economic outlook. Seen in this light, high and rising incarceration rates should be understood by bond markets as a threat to the long-term fiscal health of state and local governments.
Fortunately, activists and advocates across the country understand what the financial markets are missing. They have begun to develop strategies to challenge back-door financing of prisons, jails and detention centers by putting the public back in public finance.
When Oregon proposed building new prisons with revenue bonds, the Western Prison Project held a public series of meetings to discuss a possible taxpayer lawsuit and flooded the State Treasurer with phone calls – ultimately drawing attention to and postponing the bond sale. Colorado’s Criminal Justice Reform Coalition filed suit against a sale of certificates of participation for a supermax prison under that state’s tough constitutional protections for taxpayers. And North Carolina anti-prison activists tried to persuade legislators that a scheme to privately finance construction of three new prisons was overpriced, fiscally unsound and undemocratic.
None of these efforts ultimately succeeded in blocking the financing of new prisons but they helped raise a public debate over what was previously an invisible issue. Local campaigns to oppose the construction of new jails and detention centers from Memphis, Tennessee, to Laredo, Texas, have also highlighted financing concerns. In 2004, advocates and activists concerned with prison finance gained a new tool to break down prison finance deals. – a website that contains a wealth of information on revenue bonds and their use in prison expansion.
Ultimately, increased attention to the issue may persuade both policymakers and Wall Street that back-door prison finance is not in anyone’s long-term interest. If not, we will all pay the price for many years to come.
The author would like to acknowledge Judy Greene, May Va Lor, Mafruza Kahn and Phillip Mattera for their contributions to the growing body of prison finance knowledge. This article originally appeared in Prison Profiteers: Who Makes Money from Mass Imprisonment (New Press, 2008).
1 A bond is a security that guarantees its owner payment of interest and principal – the “face” amount of the bond – on a fixed schedule. Bonds can be bought and sold in the marketplace like stocks, but are generally considered a safer investment because the bondholder’s eventual return is largely predetermined.
2 Cooperative endeavor agreements are legal structures that allow the state of Louisiana to engage in partnerships with private parties to fund activities which are supposed to benefit state residents.
3 The Tallulah story is discussed more fully in a later chapter in this book.
4 According to PublicBonds.org, in 1996 capital expenditures accounted for $1.3 billion of $22 billion in total corrections spending.
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