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Profiting From Illiquidity

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Aug 10 2007 12:00am EDT

Profiting From Illiquidity

Nancy Trejos of the Washington Post reports that the spread between conforming and non-conforming mortgages has now gapped out to 75bp, from 20bp in mid-July. Tyler Cowen says in response that

If you think this is only a liquidity event, there is of course a profit opportunity.

I'm not entirely sure how Tyler expects me to proft from this spread. Can I buy an RMBS of non-conforming jumbo mortgages while going short a Fannie Mae bond with a similar duration? That would imply that non-conforming jumbo RMBS are trading at levels equivalent to where new jumbo mortgages are being priced, which is not necessarily the case. A lot of the rise in mortgage rates is an attempt to scare borrowers into not borrowing at all, and we saw with Bear Stearns that primary-market rates can be well wide of secondary-market rates.

More generally, you need liquidity to profit from a liquidity event. If illiquid paper plunges in price, you can buy it up (with cash), hold it to maturity, and make a tidy sum. But where's that cash going to come from? That's the question.

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