Affirmative Action, Negative Outcome

More and more U.S. cities and states are adopting affirmative-action programs in awarding financial business. From underwriting municipal bonds to managing pension funds, local governments are requiring that there be minority participation. The intention is good: to build up businesses that are owned by blacks, Hispanics, and women.

There is an economic cost, of course. Any social policy that interferes with efficient markets theoretically raises costs at the margin, even if the effect is slight. But society is supposed to benefit overall.

That's the rub. Increasingly, tiny minority firms are acting as fronts for big financial firms, parlaying their political contacts into fat fees. This is especially true in the municipal-bond market.

Take California. The state mandates what are, in effect, affirmative-action targets for each muni issue: 15% for blacks and Hispanics, 5% for women, and 3% for disabled vets. These mandates provide a strong incentive for Wall Street to team up with minority-owned finance houses. But only about a dozen such minority firms in the country have the capital and experience to do the job. The rest go through the motions and front for the big players.

Worse, many are owned and controlled by the larger firms. In the money-management game, large firms solicit money-management and trading business from pension funds by promising to fulfill minority requirements through an affiliated firm. Fair enough--except when that minority firm is really captive, using capital and computers from Wall Street houses to execute transactions.

Fronting has been a problem in government set-aside programs in construction and cable TV for years. Now, it is becoming a serious issue in municipal finance. If the goal is to build strong minority businesses, then fronting is an insult not only to taxpayers but also to legitimate minority businesspeople struggling for a place in the corporate sun. It may be legal, but it isn't right.

Before it's here, it's on the Bloomberg Terminal.