Tuesday, June 17, 2008

Housing Foreclosure and Local Community Quality of Life Degradation

Suppose that you are a home owner in some suburb and for random reasons your 10 closest neighbors default on their mortgage payments. Do their actions lower your quality of life? It is possible that they defaulted because they anticipate that their equity is negative and that home prices will fall further. If their home price dynamics are correlated with yours, then their default will predict a further price decline of your house but this doesn't mean that their default CAUSED your house to fall in price. The key counter-factual here is what would have been your home price dynamics if your neighbors hadn't defaulted.

In thinking through some of the local quality of life issues related to neighbor default, I post this; My Anderson Forecast Presentation

Here is the core argument. There can be a cross-neighbor negative externality if when my neighbor defaults his house remains vacant for months and becomes a crack-den. In this case, my quality of life can decline because of the "new news" that my house is adjacent to a scarry place. The Mayor of Los Angeles believes that this is a serious issue in at least 10 zip codes in LA. Beverly Hills 90210 is not one of them but 90002 is.

What is the market failure here? As this blog entry makes clear the issue is "who is the residual claimant" on a house when it goes into default?


If there was a single bank who now owns the house after a default, this bank could turn around and sell to a renter and the house never becomes a crack-den --- there is no externality in this case just a transfer from the original owner who loses $ on the sale to the lucky renter.

BUT, if many investors each own a small % of a mortgage then a transaction cost issues arises for how this mortgage is aggregated into a single claimant. The answer here might be random assignment. For the pool of defaulted homes, each of these homes should be allocated in a lottery system where the banks have more lottery tickets if they owned a larger % of the last mortgage. My proposal would reduce transaction costs of determining who owns the house after a default and would reduce vacancy times and thus minimize the "vacancy" externality.