Earlier in August 2012, investment banking firm Goldman Sachs (NYSE:GS), hoping to shed an image that a writer in Rolling Stone magazine once referred to as a "great vampire squid wrapped around the face of humanity" because of its quest for "anything that smells like money," announced an agreement with New York City to issue a social impact bond. The bond will have Goldman invest $10 million in a jail initiative and the hope is that adding a profit incentive to the agreement will help reduce the number of repeat offenders coming out of the Rikers Island Prison Complex, which is one of New York's main prison facilities.

The program specifically covers adolescent males who are convicted of crimes and end up at Rikers. According to details of the program, Goldman will receive its money back if it reduces the incidence of repeat crimes by 10%. If recidivism falls by more than 10%, Goldman can make a profit of a couple of million dollars. If it falls by less than 10%, Goldman can lose as much as $2.4 million. Mayor Michael Bloomberg's personal foundation is also in on the mix and will cover some of Goldman's potential losses. If the program turns out better than planned, New York will be able to use some of the capital committed by Bloomberg to create similar bonds.

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What Are Social Impact Bonds?
The bonds issued by Goldman are referred to as social impact bonds. These bonds are meant to marry the benefits of the private and public sectors for the benefit of a specific social purpose. Specifically, they employ private capital to serve public purposes, such as the Rikers Island initiative to reduce crime rates among younger people.

Social impact bonds are believed to have been first used in the United Kingdom to reduce recidivism in a prison in Peterborough, England. The use of the bonds has since spread to Australia and Massachusetts, where they are being used to help lower homeless rates and also help reduce criminal activity among younger people.

A recent study on social impact bonds estimated that they can ideally help lower the costs of social programs, increase the adoption of strategies and tactics to reduce crime, lower homelessness and benefit any related social program they are designed to tackle. This could eventually lead to quicker learning curves, if social impact bonds serve their intended purpose.

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The Down Side
Of course, there are critics who believe placing a profit motive behind social programs could prove detrimental to their intended purpose. For instance, if not designed with the right incentives and proper checks and balances, certain issuers could cut corners to make a buck and may end up negating the social benefit these bonds are meant to achieve.

On the flip side, the simple fact that these programs are not meant to be profitable may mean that the social impact bonds don't end up making money for the underlying issuer. Since this is the partial goal of the issue, this could limit the adoption of social impact bonds going forward. In Goldman's case regarding the Rikers Island bonds, it stands to lose only as much as $2.4 million which sounds high but really isn't for Goldman, given it reported profits of close to $1 billion during its most recent quarter.

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The Bottom Line
Cynics may try to point out that Goldman is issuing the bonds to improve its public image, as opposed to the small amount of profit it stands to gain if the Rikers Island program works out. The social impact bonds could end up serving a worthy purpose, however, and could be expanded greatly if they prove successful. In a few years, it is possible we will see many more investment banks issue these bonds and the potential for billions of dollars in notional value.

Ryan C. Furhmann does not hold any stock in companies mentioned in this article.

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