The discrepancy between inherent value of assets and market price of assets seems to be widening out with every given day. Yes, data released this week shows that the mortgage delinquency rate for the fourth quarter of 2008 hit a record 7.88% and 1.88% prime loans are in foreclosure. (Remember, when the prime delinquency rate was below 1%?) Such credit performance certainly implies a dire situation, but does it imply as dire a situation as current bond prices imply?

For the last few weeks I have been answer this question with a “no.” Mortgage bonds trading below 70 don’t deserve such prices because, in many cases, their underlying mortgages will not chargeoff to the degree implied by today’s prices. This disparity in price has sustained me in recent weeks. At some point, I have thought to myself, market price and inherent value will meet at a lovely cafe on the bank of some sparkling river and enjoy a coffee together — and the economy will be right again. Prices will match the inherent value, which is really all that the economy wants. Say goodbye to the recession, folks.

I am wrong though. This price disparity is not going to resolve just because the inherent value of the assets backing the financial instruments (i.e. mortgages) is greater than the value implied by today’s bond prices. I understood why after reading today’s post by David Merkel, who writes The Aleph Blog:

I have seen private residential mortgage bonds trading at levels where I said, “The odds of these not being money good are remote.” Yet, the bonds trade (if they trade) below 70. (100 is being paid in full.)

We developed too many speculators in the 2000s, and not enough parties that would hold assets to maturity. We now suffer for that, including our dear government. …

This is a powerful point. The issue is not an imbalance of inherent value to market price, but an imbalance of inherent value and investor patience. Such an imbalance is not cured by a change in valuation or mortgage credit performance, because it is currently hardwired into Wall Street. Unwinding that is not easy. And if that is the case, other factors must change in order to resolve our economic predicament, as Merkel writes:

An overage of private and public leverage pushed asset prices above their equilibrium levels. Residential housing is a good example here. Prices still need to come down to restore the affordability levels that existed through the second half of the 20th century. The Fed could inflate some of the problems away, but that does not seem to be on their menu of choices at present.

“Inflating some of the problems away” is an idea that I first heard last fall, yet it remains very much on the backburner. The Fed, as it turns out, is not hardwired to allow for inflation. I don’t want to speculate on an inflationary strategy, but I will say that after reading Merkel and others, I am more convinced that the status quo most likely needs to be reconsidered, if the US economy is to spark to life anytime soon.