Foreclosure Externalities:

Two recent articles have raised an issue that I've been thinking about as well. First this one by Jim Prevor and this one by Alan Reynolds in the New York Post.

The basic issue raised by these articles as whether there is a "foreclosure externality" from a house going into foreclosure and thereby reducing property values for neighboring houses. The point here is different from one simply of supply and demand. The argument is not that a foreclosure increases the number of houses for sale and thereby depresses prices. But rather that an abandoned house brings disrepair, crime, and other problems that depress surrounding houses. A lot of weight has been placed on one article that finds a $3000 negative externality for surrounding houses. As Prevor notes, however, this is probably overstated for several reasons.

One reason is that any effect appears to be temporary, not permanent. There are widespread reports now of foreclosed houses turning over in resale markets, so it may be that the duration of any externality is much shorter-lived than previously thought.

We also don't know whether the marginal negative value is actually linear or whether it has declining negative marginal value. Thus, even if the third foreclosure depresses prices $3000, what about the thirteenth? The twenty-third? It seems implausible to think that the marginal negative value remains constant. Finally, that study was conducted when house prices were at their peak; now that home prices have fallen dramatically, it may be that the negative foreclosure effect is much smaller.

Reynolds notes that the foreclosure problem is not uniform across the country, but that there are actually a handful of states and other hotspots around the country with unusually high levels of foreclosures. This suggests that if there is a foreclosure externality it is concentrated in a few places--the overwhelming number of Americans, however, suffer no foreclosure externality.

Why does this matter? Because the presence of a foreclosure externality has been advanced as an argument for reducing the number of foreclosures as an end in itself, rather than trying to distinguish between "worthy" and "unworthy" homeowners. In particular, I think that this goes to the question of whether we should allow principal write-downs in order to eliminate the incentives for a homeowner to walk away from an underwater mortgage.

We can think conceptually about two groups of people: those who want to keep their houses but can't afford it (say because they had an increase in their interest rate on an ARM) and those who could afford to keep their houses but are making a rational economic calculation to walk away because the house is under water. These are stylized differences of course--both elements are present to different degrees in different cases. There seems to be some popular support for helping the first type of homeowner and foreclosure rescue plans to date have focused on that issue. But the second type of person can be helped only if we are willing to allow a write-down of principal. Foreclosure rescue plans to date have generally refused to bail-out the second person by allowing principal write-down.

If there is a modest or non-existent foreclosure externality, then the case for reducing the number of foreclosures as an end in itself becomes weaker, and instead we may want a more nuanced plan that focuses on helping some homeowners but not others. If a person could make his payments, but chooses not to because the home is underwater, then the question is whether we should essentially bribe him not to walk away from his home. The only real reason to do this is if his walk away will hurt the rest of us--what amounts to essentially an extortion threat. If that threat is largely toothless, however, then the argument for giving in is hard to see.

Without some sort of foreclosure externality, what is going on in many of the markets where we see large-scale foreclosures is nothing more than supply and demand—there are simply too many homes that were built and prices have to fall to their market levels. This seems to explain the situation in the exurbs in California, Las Vegas, Phoenix, Tampa, etc. Prices have fallen because there are just too many houses, not because of foreclosure externalities. And we can't repeal the laws of supply and demand.

Thus we are left with a bit of a conundrum. There are undoubtedly many people who we think worthy of helping stay in their houses, such as those who have had a sudden unexpected increase in an ARM and want to keep their homes but can't afford it. If we can help get those people into a lower-interest fixed mortgage, then great, that seems like a worthwhile foreclosure-rescue plan to me.

But there are a lot of other people—-perhaps a majority in some places at this point-—who are walking away as a rational response to the incentives they have, some of which are pernicious incentives established by state law, such as state antideficiency laws that let them walk.

So we are left with the possibility that if we help everyone we think is worth helping (and only those worth helping, we will help a lot of worthy people but will only make a small dent in the foreclosure problem. To make a substantial reduction in the foreclosure numbers we would have to be willing to write-down principal and give in to the threat that those who are underwater will walk away.

So far policymakers have generally resisted allowing massive principal write-downs, including the most recent Obama proposal. The Obama plan focuses on making payments more affordable, and in so doing, may deliver help to those we think we want to help--those who want to keep their homes but are unable to afford it. But it does not allow principal write-down and so thus eschews giving relief to those who could afford to keep their home but choose not to. If this is so, it may result in helping many people but doing little to staunch the overall tide of foreclosures.

In the end, however, this may be a completely defensible compromise--do everything we can to help make payments affordable but not allow principal write-down which would essentially be a bribe to those who are walking away from their homes as a rational economic calculation because they are underwater. With respect to the latter group, the market seems to be working sufficiently fine to recycle these houses back onto the market in foreclosure sales.