Long-Term Investments : ‘Three Strikes’ Law Will Boost Wall Street Firms That Sell Bonds to Finance Construction

Wall Street will be one of the biggest winners as California builds prisons to house felons sentenced under the “three strikes” law.

Since 1984, big investment firms have made more than $35 million from this state’s prison construction program. As more prisons are built to house “three strikes” inmates, they will reap far more.

To finance prison construction, California sells two types of bonds--traditional voter-approved general obligation bonds and more complex lease revenue bonds.

Voters approved general obligation bonds five times between 1982 and 1990 totaling $2.4 billion. Interest to be paid on the bonds will bring that sum to $4.1 billion. But in the early 1980s, legislators concluded that voters would not approve all the debt needed to build prisons. So in 1984, legislators changed the law enabling themselves to directly authorize lease revenue bonds to build prisons.

The Legislature and the two most recent governors have approved the sale of $2.9 billion in lease revenue bonds for prisons. By the time the lease revenue bonds are paid off, the total cost will be $5.6 billion.

To sell the bonds, the treasurer turns to Wall Street. Investment firms such as Morgan Stanley and Goldman Sachs form syndicates to buy the bonds at a discount, then resell them.

Retailers market the bonds as safe long-term investments to consumers. Treasurer Kathleen Brown has sold prison bonds in denominations as small as $250 as part of a program to help families save for college tuition.

The legislative analyst contends that lease revenue bonds cost taxpayers 20% more than voter-approved bonds in higher interest rates and administrative costs.

Bond defaults are not unheard of. The most infamous example came in 1983 when, to the horror of 25,000 investors, the Washington Public Power Supply defaulted on $2.25 billion of lease revenue bonds when it failed to complete nuclear power plants in Washington state.

Experts say there is no chance that California will go the way of the utility that came to be known as WHOOPS. “We’re way overcrowded. There is a lot of stability in this,” said G. Kevin Carruth, chief of the state Department of Corrections construction program.

Because lease revenue bonds do not require a vote of the public, corrections officials say they can be approved more quickly, which speeds construction and can save taxpayers money.

“If the job of government is to be more efficient and more effective, and to accomplish a job, you want to be able to move,” Carruth said. “There is a cost to delay, a very significant cost.”

San Francisco investment banker Thomas Dumphy helped devise the concept of using lease revenue bonds for prisons. While working for the investment firm of L.F. Rothschild, Dumphy met with officials in corrections and in the office of then-Treasurer Jesse M. Unruh, now deceased, regarding the financing method. One Rothschild partner was Grover McKean, formerly a top aide to Unruh.

Unruh awarded the first four lease revenue prison bond deals, amounting to almost $1 billion, to Rothschild. The firm, like many involved in such deals, was a major campaign donor to Unruh.

Investment bankers say their profit margins are slim. Although the amount is difficult to determine, the treasurer’s records show that Rothschild’s discount on the four prison bond deals was $19.5 million.

From that sum, Rothschild paid various consultants, including its lawyers. For deals in August, 1986, and February, 1987, to finance Corcoran and Pelican Bay state prisons, Rothschild hired the law firm of Finley, Kumble of New York.

Finley, Kumble was a high-flying and high-powered firm that made splashes by hiring former governors and senators. In March, 1987, Rodney Blonien left his position as undersecretary of the Youth and Adult Correctional Agency, where he was in charge of prison construction, and went to work for Finley, Kumble in Sacramento.

Blonien said Unruh introduced him to Finley, Kumble partners, and urged him to join the firm. “Jess took a liking to me,” Blonien said. “He told me he would be helpful to me if I went into private practice, and went into bond business.”

McKean said Finley, Kumble’s work was solid. The law firm might have gotten more bond work, but it broke up in late 1987 amid litigation among its partners and lawsuits by clients.

In recent years, the job of underwriting prison bonds has been spread among several investment houses. In a 1990 deal, an investment house that employed former Orange County Assemblyman Richard Robinson, who left the Legislature in 1986, won the contract to be lead underwriter.