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Many academics and policymakers think that asset prices have deviated significantly from
"fundamental values" and that this deviation is part of the problem affecting financial
institutions. For example, if mortgage and credit assets, which banks hold in plenty, are
currently priced below "fundamental values," then banks will be assessed larger losses than
they otherwise would. This in turn can lead to binding bank capital requirements, concerns over
banks defaulting, etc.
But, what is fundamental value, and how can one make these sorts of statement? The notion
that one can accurately assess fundamental value on the most toxic mortgage-backed securities
should be rightly treated with some suspicion. However, there is considerable evidence that
arbitrage forces, which we normally take to be the key enforcer of fundamental value
relationships, are not present in today's environment. This is circumstantial evidence for
"fundamental values" and that this deviation is part of the problem affecting financial
institutions. For example, if mortgage and credit assets, which banks hold in plenty, are
currently priced below "fundamental values," then banks will be assessed larger losses than
they otherwise would. This in turn can lead to binding bank capital requirements, concerns over
banks defaulting, etc.
But, what is fundamental value, and how can one make these sorts of statement? The notion
that one can accurately assess fundamental value on the most toxic mortgage-backed securities
should be rightly treated with some suspicion. However, there is considerable evidence that
arbitrage forces, which we normally take to be the key enforcer of fundamental value
relationships, are not present in today's environment. This is circumstantial evidence for