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