When it comes to getting someone to make a market in a community bank's stock, it seems like there's no way to win.
So-called SOES bandits are taking away much of the profit that market makers earn by dealing in these stocks. As a result, some market markers are chopping back the number of banks they are willing to position and trade.
What makes this ironical is that until recently many community banks resisted the idea of putting the trading of their shares in dealers' hands.
For generations, most small-bank shares were handled out of the CEO's desk. If you wanted to buy, he would sell you shares. If you wanted to sell, he would by them or arrange a sale.
What about price? He would set it. And usually he would say, "Well, the last sale was at $20, so let's make it $20 a share."
It doesn't take too much thinking to realize that under this system share prices would remain at $20 year after year. And naturally, as the bank grew and book value increased, this $20-a-share price became a pretty good bargain. So the CEO often would by the stock himself, or sell it to board members or other insiders.
It was not a pretty picture.
In recent years this has changed. Most community bank CEOs, judging the old procedure unfair (and also afraid of lawsuits), have bowed out of market making, leaving it to professional dealers.
Sometimes this has meant a good deal for the public. But sometimes you could drive a truck through the spread these dealers made between bid and asked prices.
How can you consider a transaction fair to either buyer or seller if the stock is quoted $6 bid and $7 asked, and then the principals are forced to pay a commission, too? That's 20% of value as the cost of a trade!
Dealers explained that they had to risk their capital, and that bank stock markets are pretty thin. "When in doubt, spread it out" is the old dealers' cry.
That certainly made sense when dealers were stuck with unsalable bank shares that drained capital when prices plummet. But competition, publicity, and regulatory pressure now appear to have minimized this spread problem. The result is that many bankers and bank stock buyers are now fairly well satisfied with the markets being made.
But now the SOES bandits are roiling the market for bank shares and other thinly traded over-the-counter stocks.
SOES, the small order execution system, is a way for market makers to handle trading in several hundred stocks at the same time. It lets any dealer automatically call on any market maker for 1,000 shares of any stock it is offering on the Nasdaq market - at the posted rate. No personal attention is needed.
The trouble is, some of these traders - the SOES bandits - have such sophisticated computers that they can tell whenever any dealer is lagging in changing a quote on a particular stock. These traders can automatically hit a lagging dealer for the 1,000 shares at a price that is now too low, or can force the dealer to buy at a price that is no longer in effect. And all by computer.
With 250 stocks to price continually, it is obvious that a market maker is not going to be able to follow all of them continuously. So the SOES bandits' computers hit dealers many times a day for underpriced or overpriced stock.
The result is that market makers withdraw, by spreading their quotes or simply positioning fewer stocks.
Who is the loser? Naturally it is the bank, or some other company that wants a liquid and efficient market for its stock and the individuals who buy and sell it.
So here is another worry for community bankers.
Many are trying to keep on good terms with their market makers by being fair with them. This involves giving they a chance to bid on all investment activity the bank does. It also means developing dividend reinvestment programs, so that dealers know there will periodically be new demand for shares - demand that will eventually help them out of their positions if the market is thin.
Maybe the Securities Exchange Commission and the National Association of Securities Dealers will be able to do something. I hope so.
Because if SOES bandits continue to drain profits from market makers, the latter may feel that risking their capital in bank equities is a bad bet.
If that happens, bank CEOs may once again say to the widow trying to sell her shares, "Well, the last trade was $20, so I think I can get you $20 for the stock" - even though book value and earnings make the $20 quote as obsolete as the steam locomotive.
Mr. Nadler, an American Banker contributing editor, is professor of finance at Rutgers University Graduate School of Management.
