April 6, 2006

Say an obscure municipal bond with some unusual features hasn't sold for several years. A customer wants out of 5 of the bonds but the retail broker is unwilling to take a position in the bond because the broker doesn't know what it's worth. The broker solicits bids directly or through a third party. We are a broker dealer with a trading operation and our trading operation specializes in small lots of obscure bonds. We think the bond is OK but also think there is not much retail market and so bid $90. We are the high bidder which means everybody else thought it was worth less or did not want the bond. The customer still wants out at this price. We take the bond and immediately reoffer it to the street at $96, which gives an ultimate yield higher than similar, but more marketable, bonds-- even after allowing a large retail mark up. We intend to try it there, but expect only to get something better than $90. A retailer buys it at our offer of $96, marks it up to $99.5, and sells it to his customer. Both these mark ups are large but allowable under the current practice and the proposed rule. The $3.50 retail mark up is less than 5% and the $6 mark up is wholesale.

Now say a second lot of 5 of the same bond comes on the market in a few weeks. The trade can see the last retail sale @ $99.5. The bond appears marketable and has a competitive yield even when priced over par. A retailer bids $100.5 and marks the bond up to $101.5. A one point retail mark-up is actually less than standard for a bond like this at a typical retail house.

After a few months go by, if no other transactions occur, the bond will be no more marketable than it was when the process described above began. If the customers then want out of the bond, who had the fairer purchase price-- the customer who paid a $6 + a $3.50 mark up but owns the bond at $99.5, or the customer who paid a 1 point mark up but owns the bond at $101.5?

The problem with the proposed rule is the problem with the existing rule; the customer deserves a fair price, not a certain mark-up. If mark-up is allowed to be a proxy for fair pricing, then fair pricing will be secondary to mark up or ignored altogether. In highly liquid markets, it would be difficult or impossible to have a fair price and a large mark-up. In highly illiquid markets, mark-up can have little to do with fair pricing.

Dan Mayfield
Sanderlin Securities