Moral hazard and stopping single-family foreclosures

One of the things I like about being at USC is that I am in the same school as real estate economists. In looking at the various plans to bailout homeowners, I have differed consistently from my one of my favorite colleagues, Richard Green, on whether we should be preventing foreclosures. Green is a well-respected real estate economist, and so his is the better informed opinion here. The dueling issues: moral hazards versus externality effects.

On the one hand, homeowners, especially those who over-invested in real estate, speculated with their homes. This is a terribly cold thing to say, but markets discipline that type of behavior, and we could perhaps argue that the entire bubble induced its own weird form of moral hazard. People who knew little about the actual market believed that they were guaranteed speculative returns in real estate with virtually no research or knowledge about the transactions they undertook. That’s a kind of moral hazard in way, where you engage in risk-taking behavior believing that the costs associated with losses won’t accrue to you. As Daniel Friedman says in Morals and Markets: “Why not sit at the blackjack table if you are gambling with somebody else’s money?” It’s pretty clear, at least to me, that this type of home-buying behavior has been bad for just about everybody: the consumer, urban form, and in the end credit markets. The consumer overconsumes housing and housing credit, with predictable effects on urban form in many regions (not all), and with the obvious consequences for credit markets we’re in now.

On the other hand (there’s always another hand), foreclosures are not occurring randomly across metropolitan geographies. They are clustering in particular neighborhoods, which has led some economists to argue that there are externalities for other home owners–that is, there is a price effect on their home over and above market-induced price decreases. Because of those externalities, there is a public policy rationale for foreclosure assistance.

While I don’t mean to be hard-hearted, I wonder about this externality effect. I work predominantly in externality theory, and the more I work there, the more stubborn I get about not accepting externalities as an a priori rationale for public policy intervention. In cities, just about everything has externalities; we’re in the same geographic container, and what we do to the built environment affects us all, both as individuals and groups. So unless we’re prepared for a lot of intervention, we need to think about degrees of externality rather than the mere existence of them.

In addition, I also wonder why we can’t prevent the perceptions that areas are in decline–what I presume is the externality associated with clustered foreclosures. Why can’t we just control information? For example, when Oak Park, IL, decided to combat white flight in response to black homeownership, they prohibited “for sale” signs in front of houses. So rather than having “for sale” signs crop up around houses newly purchased by black residents, the city of course allowed people to dispense with their private property as they saw fit, but the city didn’t allow these homeowners to geographically “out” the new black residents. You still can’t put “for sale” signs up in Oak Park. Disallowing for sale signs strikes me as much easier to do now than back when Oak Park originally did it–internet real estate listings are ubiquitous.