A Proposal to Save California Taxpayers Money on State Prisons

By Curt Pringle

California has declared war on crime – increasing the penalties on criminals and increasing the funding available for law enforcement. As a result, crime rates in California have plummeted, our streets are safer, and our prisons are full. Pringle proposes commonsense changes to the way prison construction is financed to save taxpayers nearly $400 million while meeting our public safety needs.

• Utilizing available short-term notes rather than funds from state pools.
• Using variable rate long-term bonds in conjunction with fixed rate long-term bonds.

Background.

The California Legislature has enacted a number of landmark anti-crime bills during my tenure in the legislature, including the three strikes law, a one strike law for sexual predators, and laws requiring mandatory prison terms for violent crimes. These important measures have resulted in an unprecedented reduction in crime in California. While all of California applauds these important efforts to reduce violent crime, we must also be concerned about the significant cost to California taxpayers for housing the increased state prison inmate population. Now that we catch more criminals and lock them up for longer periods, the prison population has grown from 23,511 in 1980 to 152,506 in 1997 and is estimate to expand to more than 213,400 inmates by 2003(1).

Despite a construction program that has resulted in the completion of 27 major prison projects since 1993, we face the daunting task of adding capacity for the 61,000 projected additional felons that will come into the system. Under our present financing system, the cost of building each new 4,600-inmate prison is approximately $280 million (2). In the past the Department of Corrections has used a combination of general obligation bonds sold by the State Treasurer and leased revenue bonds issued by the State Public Works Board to pay for prison construction when the state could not finance on a "pay-as-you-go" basis. In keeping with this practice, Governor Wilson's proposed 1998-99 budget included over $1 billion in State Public Works Board lease revenue bonds to pay for new state prisons.

In order to face the prison capacity demands of the future in a more cost-effective manner, I propose that the State Public Works Board make two important changes in its prison financing program which will reduce the financing costs that must be paid by California taxpayers:

• First, interim financing should no longer be provided by internal borrowings from the State's Pooled Money Investment Board. Instead, interim financing should be obtained by the State Public Works Board by selling short-term tax-exempt notes in the commercial paper market.

• Second, long-term financing for the new prisons should not be provided solely by using fixed interest rate bonds, but rather by integrating them with variable interest rate bonds which are available at a lower interest cost.

Proposal #1: Short Term Notes.

Interim construction financing for prisons before long-term bonds are sold has traditionally been provided by having the State Public Works Board borrow money from the state's Pooled Money Investment Board (3). The trouble is that these loans are required to pay interest at taxable rates because the funds are being lent from a state account. Therefore, I propose to have the State Public Works Board instead borrow interim construction financing in the commercial capital markets where it is available at lower, tax-exempt rates.

State Treasurer Matt Fong has recognized the potential for similar savings in other state programs and in 1996 began selling general obligation bond notes in the commercial paper market instead of borrowing from the Pooled Money Investment Account. His program has saved taxpayers approximately $25 million to date. I would like to see a commercial paper program instituted at the State Public Works Board to likewise provide low-cost interim financing for prison projects.

Proposal #2: Variable Rate Bonds. My second proposal is to provide long-term bond financing for new prisons using variable interest rate bonds instead of fixed rate bonds. Many Californians are familiar with variable rate debt, for example through their variable rate home mortgages. State and local governments also borrow using variable rate debt. Just as variable rate home mortgages usually have a lower interest rate than fixed rate home mortgages, variable rate municipal bonds usually have a lower interest cost than fixed rate municipal bonds. More importantly; in this decade there has never been a time when a municipal bond issuer could have issued bonds at a fixed rate for a cost lower than variable rate bonds (4).

Consider this example to explain the value of this proposal. On April 30, 1996 the State Public Works Board issued $455,400,000 in fixed rate bonds for the Corcoran prison at a true interest cost of 5.95% per year (5). If those bonds had been issued as variable interest rate bonds with interest to be adjusted weekly, all the interest and other costs through March 31, 1998 would have averaged only 3.615% per year, resulting in savings of over $21 million (6). Therefore, if the State Public Works Board sold the proposed $1.024 billion in prison bonds as variable interest rate bonds, and obtained the same interest rate differential as in the example over its 25 year life, then it would end up saving taxpayers over $383 million.

Safeguards.

As the state engages in the use of variable rate financing, it is appropriate to have safeguards in place to ensure this program delivers on the promise of reduced costs. In this regard, two additional points are worth making pertaining to variable rate debt. First, if the State Public Works Board became concerned in the future that variable interest rates were creeping upward, then it could either convert the variable rate bonds to fixed rate bonds or cap the state's variable rate exposure by purchasing interest rate caps in the open market. Second, credit rating agencies and analysts that monitor the state's finances would become alarmed if all of the state's debt were converted to variable rate debt and I am not suggesting that we do so. Rather, my suggestion is that we issue not more than approximately $1 billion of variable rate bonds at any time. This would limit the state's short-term and variable rate debt exposure to about 20 percent of our total debt; a level that credit rating agencies and analysts accept as reasonable (7).

Conclusion.

Californians rightly expect the Legislature to continue its firm anti-crime stance. The safety of our neighborhoods and families rely on it. At the same time, we must provide for the just punishment of criminals and avoid early releases due to overcrowded conditions. We know, however, that taxpayers do not want to give the state a blank check to cover prison construction and operations. Californians have a number of other important priorities on which savings in prison construction could be used. As we build needed prison facilities, we must monitor and control costs everywhere we can. With this in mind, I believe that my proposals will allow us to meet our prison needs while both saving taxpayers money and maintaining the state's credit rating.

Notes:

1. Source: Department of Corrections at page B-3 of Preliminary Official Statement of State Public Works Board of the State of California dated March 13, 1998.

2. Source: Department of Corrections.

3. Each official statement for State Public Works Board prison bonds discloses that a portion of the proceeds will be used to repay an interim loan provided to the Board by the Pooled Money Investment Board for moneys advanced to the Board to pay project costs. See page 1 of the Preliminary Official Statement cited in footnote 1. According to the State's Treasurer's office, the Emergency Beds programs described in that preliminary official statement borrowed from the Pooled Money Investment Board at interest rates ranging from 5.63% to 5.72% and the total net interest paid was approximately $6.3 million.

4. Attached is a chart depicting fixed rates at which bonds could be sold since July 1989 and a variable interest rate index (weekly variable rates). This illustrates that variable rate bonds have provided the lowest cost of capital during the period. This is also true for periods prior to July 1989.

5. State Public Works Board of the State of California Official Statement dated April 30, 1996.

6. Attached are computations comparing debt service at 5.95% and debt service at the PSA/Bond Market Association seven day variable rate index (an average of about 200 issuers). The State's actual rate would be approximately 20 basis points below the index but we used the index on the assumption that bank line of credit fees and dealer remarketing fees would total approximately 20 basis points.

7. According to the Governor's Budget Summary 1998-99 at pages 178-179, as of the end of calendar year 1997, California owed $14.9 billion in principal on non-self liquidating general obligation bonds and $7.2 billion in principal on lease-revenue bonds for a total of $22.1 billion. To compute total debt, we add $1.5 billion (maximum amount of general obligation commercial paper that may be outstanding) plus $3 billion (annual RAN borrowing) plus $1 billion (the bonds I am proposing) for total debt of $27.6 billion. 20% of $27.6 billion is $5.5 billion, which would consist of the above-mentioned $1.5 billion in commercial paper, the $3 billion RAN borrowing and $1 billion in variable interest rate prison bonds. Standard & Poor's said in Credit Impact of Short-Term and Variable-Rate Debt, Spring, 1997 that "The level of variable rate and short-term debt depends on an issuer's financial strength, composition of assets, ability to match assets with liabilities, and other hedging strategies. Historically, Standard & Poors considered total short term and variable-rate exposure15% to 20% of outstanding debt as an upper limit. This is not a steadfast rule. With issuers that have limited revenue flexibility, such as lease or appropriation-backed bond issuers and sales tax backed issuers, the upper limit is much lower. On the other hand, issuers with competitive rates or tax advantages and significant short-term assets can handle variable and short-term debt well in excess of 20% of total debt…"