WASHINGTON -- Certificates of participation that finance for-profit prisons have emerged as the riskiest category of lease securities, with the nine defaults on such issues since 1990 constituting more than a third of lease defaults nationwide, a study released last month by John Nuveen & Co. says.

The report, by analyst John Illyes, nevertheless finds that many prison lease issues are creditworthy and provides advice on how to avoid the bad apples in this growing sector of the lease market.

"Over $100 million of prison issues defaulted in 1992 and 1993. These defaults tend to cast a cloud over the multitude of legitimate jail COPs which deserve market recognition," Illyes writes.

All of the nine jail lease defaults involved for-profit prisons for which securities were issued before the owners had contracts to rent cells to state and local governments to house inmates. The owners proved too optimistic in counting on business generated by overcrowded publicly owned jails.

Eight of the jail defaults occurred in Texas and one in Minnesota, the study says. Given a nationwide total of 25 lease defaults since 1980, the for-profit jail issues have earned "the highest default rate of any type/purpose ever funded by leases," the report says.

"Speculative jail COPs may be the most fundamentally flawed credits ever offered to tax-exempt investors and mutual funds," the study warns. "The Texas jail COP financings were not rated and were clearly advertised as high-risk investments for sophisticated buyers. But these so-called ~high-risk' COPs were really ~no chance' COPs."

Despite the advertised risks, at least three of the speculative jail issues were purchased by large institutional investors, and the investors ended up receiving only 50 cents on the dollar after the empty jails were condemned and taken over by Texas authorities, the report says.

The study says the rash of Texas defaults since 1990 appears to have "run its course," especially with the demise of the Houston-based N-Group, the company that built six of the failed prisons. But the report warns that other for-profit jails are planned or under construction and still could pose risks.

"Based on anecdotal evidence, we believe some 20 local for-profit prisons exist or are being financed ... These range from fully completed facilities desperately seeking prisoners to COP issues coming to market" in states ranging from Georgia to California, the report says.

Unlike prisons that are owned by a state or local government, for-profit jails are not essential to the owners or the municipal users. They also are not rated and carry greater than usual political risks because they do not have a public mandate, the report says.

On the other hand, for-profit jail financings that are issued with one or more prisoner contracts in place appear to offer lower risks. The report notes that about 100 such issues are outstanding, of which three have defaulted.

Publicly owned jails that are rated and have the backing of a general fund or revenue pledge appear to enjoy the best records. Of more than 100 such credits outstanding, none have defaulted, the report says.

However, even financings for publicly owned jails, which have generally been classified as low-risk because governments regard them as essential, are plagued by some risks associated with jail financings, the report says.

The risks include a growing number of civil rights and liability lawsuits stemming from riots and overcrowded conditions, and the "not in my backyard" syndrome in which voters say they want to build a jail but do not want it located near their residences.

Also, some jail lease financings previously have been rejected by the voters as general obligation issues, demonstrating that they do not have strong public backing. "A prison -- or any other controversial project -- can entail serious political risk, and needs more scrutiny than other projects," the report says.

A court order or other legal mandate to build a prison can provide some comfort to investors in case of any political resistance, the report says.

An occupancy agreement and a gross revenue pledge also appear to be essential to ensuring the creditworthiness of a prison project. But other typical lease features such as a lien on the prison property provide little security, the report says.

"Re-entry and eviction are common lease provisions which a judge might overrule if the project is truly necessary," the study says. "It seems more likely that a court would rule that the prisoners stay and that the lessee and investor work out a repayment plan."

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