The Cost of Foreclosure
(wikimedia)
Way back in December of 2007 when happenstance led me to write a piece about foreclosure clusters, I was interested to learn that foreclosures are bad for everyone who owns a home on the block. It’s not, in other words, really just a matter between a borrower and his bank. Under the circumstances, as Mike at Rortybomb explains there’s something not very pragmatic about the laissez faire approach to home lending:
If I was a degenerate crackhead who snuck into your neighborhood and mugged you for $50, the Wall Street Journal Opinion Page would want me thrown in jail. Now imagine that I’m a degenerate crackhead who took out a subprime loan to move next door to you, in an arrangement that I’m likely not going to pay off. I might not even make one payment. If I default you’ll lose 10% of the value of your home from the externality effect. Assuming your home is worth $300,000, there’s a 20% chance I default in 2 years (realistic numbers), and you lose 10%; 300,000*.2*.1 = I’ve just robbed you for $6,000 while the Wall Street Journal Opinion Page cheered me on. And that’s one house – I’ll have a dozen neighbors. Now mind you, the product was great for me – I got to smoke crack indoors, in a house I could never realistically afford, which was a big plus. The subprime lender sold my loan to a pension fund in Denmark for a nice fee. It goes in the win column for us.
I don’t think the analogy to a mugging works in all respects. Still, I think the main point holds, there’s perfectly good reason to regard the viability of these arrangements as a matter of general social concern and there’s also good reason to want people to err on the side of caution. It adds up to a substantial argument in favor of the idea of a financial consumer protection agency.
32 Responses to “The Cost of Foreclosure”
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July 9th, 2009 at 9:26 am
One might think of all sorts of Wall Street thieves whom the WSJ would cheer on, did cheer on, and still cheers on.
July 9th, 2009 at 9:28 am
That’s always been, to me, the only compelling argument in favor of helping homeowners (sic!) in trouble: I don’t care a fig about them, to be totally honest, but I do care about their neighbors and their communities. In fact, I’d be all for a plan that managed to address the latter issue without touching the former.
July 9th, 2009 at 9:31 am
Or alternatively a return to tried-and-true methods like requiring a 20% downpayment. More generally it certainly sounds to me like the ability to repackage the loan (i.e., defraud the pension fund by selling them something the bank must know is junk) is really the heart of the problem. If you leave the bank able to do that, then they still have every incentive in the world to make crappy loans – and you’re gambling that your FCPA can both outwit the banking industry and avoid regulatory capture. Not only that, but even if effective such an agency would have to walk a fine line between protecting consumer interests and pushing poor people out of nice neighborhoods. Somewhere a poor family will apply for a mortgage that’s 45% of their net income, with 5% down, to try to get their kids in to a good school district – at a rate that we can only assume the bank is going to set higher than they would for someone better qualified. What’s the FCPA supposed to do here? Scotch the deal as ‘predatory lending’ (i.e. hose the family out of their shot at the American dream)? Force the bank to eat the risk for no premium?
July 9th, 2009 at 9:36 am
Sub prime buyer drives up the price, sub prime seller subsequently drives down the price. What’s the problem?
July 9th, 2009 at 9:39 am
If I default you’ll lose 10% of the value of your home from the externality effect.
[citation needed]
This paper finds it to be closer to 1%:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1160354
July 9th, 2009 at 9:48 am
You tell ‘em, Matt.
And another thing, what’s with all these poor minorities moving into my neighborhood, driving the prices down? Somebody should put a stop to that, too. I should have a right to control anything and everything that may affect the subjective market valuation of my property, right Matt?
July 9th, 2009 at 9:50 am
Sounds like a good justification for authoritarian homeowners associations. I someone moves into the neighborhood who refuses to paint their house, lets their grass grow long, puts a car on blocks in the driveway, well, hey, he’s driving everyone’s property values down. Which is just like mugging those other homeowners. So authoritarian homeowners associations are justified!
As usual, authoritarians like Matthew are perfectly in favor or more authoritarian government arrangements.
July 9th, 2009 at 9:51 am
Dogwhistle, much? I swear I didn’t hear anything, but all of a sudden Pat Buchanan is jumping around and wagging his tail like a bloody idiot.
July 9th, 2009 at 9:57 am
Declining property values are not a problem right now, they are a market correction. Look at a long-term Case-Shiller chart. The bubble is still in the deflation phase and hasn’t gone back down to long-term norms yet.
People who bought at the top of the bubble are going to take a loss. They more or less have to.
Somewhere a poor family will apply for a mortgage that’s 45% of their net income, with 5% down, to try to get their kids in to a good school district – at a rate that we can only assume the bank is going to set higher than they would for someone better qualified. What’s the FCPA supposed to do here? Scotch the deal as ‘predatory lending’ (i.e. hose the family out of their shot at the American dream)? Force the bank to eat the risk for no premium?
This isn’t an FCPA problem, it is an educational system reform problem. Stop tying school funding to the wealth of the local neighborhood and people might stop treating housing location as a positional good. Magnet schools might help too, if the kid is as involved in his/her academic success as the parents.
Failing that, though, they can’t afford a house they can’t afford. The government already subsidizes home ownership very heavily, but there are limits to how much it can do. The American dream is largely illusionary in American reality, but in the specific case of education, I think parental involvement counts for a lot even in poor schools.
July 9th, 2009 at 9:59 am
I thought the point of a consumer financial protection agency was to protect people from banks, not to protect people from their neighbors.
July 9th, 2009 at 10:12 am
Yes, but Matt is easily confused. You could just as easily use the situation to justify a Bank Financial Protection Agency that is supposed to protect the banks and their dim-witted executives from their own venality and shortsightedness, but while this would actually be easier to implement it doesn’t really fit in with anyone’s narrative.
July 9th, 2009 at 10:15 am
As others are also pointing out, as described this isn’t a consumer protection problem, and so giving it to a consumer protection agency to handle may be a bad idea. Rather, this is really more a risk regulation issue, and so in theory should be handled by the agency doing risk regulation of the lender. Of course that sets up a potential conflict over mortgage regulations, but that kind of regulatory overlap isn’t a unique problem and can usually be resolved with the right sort of regulatory oversight.
July 9th, 2009 at 10:21 am
Do I find that I agree with Al? The idea that there’s a public interest in insuring high home values for people seems like a terrible one.
July 9th, 2009 at 10:31 am
The decline in property values in houses close to foreclosures is one of several thousand good reasons for why mortgage lending practices should be regulated in the public interest. It’s illustrative of the problems with the caveat emptor approach to lending.
But as everyone who commented in this thread has already pointed out, it’s really kind of fantastically stupid to suggest that a decline in property value amounts to theft, or that homeowners have a right to be paid a certain amount for their property. Down that road lies Jim Crow, NIMBY fascism, and seventeen other flavors of madness.
July 9th, 2009 at 10:34 am
No, not seeing it.
The much bigger externality is that easy credit to unqualified buyers forces up prices during the boom phase. So the decrease in the bust could be simply a return to what the original market price should have been.
But in the meantime there are millions of homeowners who had to overpay for an asset that is now worth less than they paid. Just like California is still overpaying for electricity after the Republican party and its accomplices (Enron etc.) performed their market manipulation fraud on the state.
July 9th, 2009 at 10:37 am
I have a way to make this rambling post much shorter and simpler:
caveat emptor
Seriously, what makes the mortgage market any different from any other market? Your 401k investment returns erode when your co-worker calls the customer service line about his account balance every other day. People pay $4 for a coffee every day because they think it is better than $1 coffee.
July 9th, 2009 at 10:39 am
Let me add that I agree with the other commenters that there are plenty of reasons to support some kind of agency to regulate mortgages. (In fact, I think that there should be some pretty draconian regulations on mortgages – such as requiring homebuyers to put 20% down for houses they are buying, without exception.) But preventing neighbors from causing declining property values in the neighborhood ain’t one of them.
July 9th, 2009 at 10:40 am
“I could never realistically afford”
But the idea here is that 20 percent fail to pay up. Meaning that… 80 percent pay up. I wouldn’t say that 80 percent success rate counts as “never realistically.” Four out of five people pay.That could be a lot better, of course. But it’s not “never.”
And, as pointed out, what about the people who movce into the neighborhood now? They are going to be paying a good chunk of change less for the same house. Which would seem like a positive externality, no?
The folks who paid $300,000 for the house do get screwed now that the price has dropped whatever percentage. But I lose a big chunk of change when I buy a car three days before a big sale. Or when I eat at Applebees three days before my senior discount kicks in.
Caveat emptor.
July 9th, 2009 at 10:41 am
The problem with the financial consumer protection agency is that it’s not going to be put in place to reduce sales of homes or weed out poor risks. Instead we’ll get a new regime of disclosure requirements without any regulation on the use of products or lending requirements to protect the financial industry from itself. Obama and crew have shown that when it comes to financial regulation, they want something just a wee bit more restrictive than the complete absence of restrictions.
July 9th, 2009 at 10:41 am
I’m confused. Which part is the WSJ in favor of? People fraudulently getting loans they can’t afford? People not paying off loans that they got (legitimately or not)? Smoking crack? This is somehow the editorial position of the WSJ?
July 9th, 2009 at 10:42 am
This is one wrongheaded post. The neighbors who lose 10% of their homes’ values because of foreclosures only gained that 10% because of the ridiculous mortgage system, which brought new buyers into the market. So they gain and lose because of your “crackhead.” Of course, in reality those crackheads were actual American families with bad financial sense. They deserve to lose their assets. They don’t deserve to be compared with criminals.
July 9th, 2009 at 10:47 am
I am, BTW, in the process of selling my house. And AFAIK, there aren’t any foreclosures in my neighborhood. Yet, still, the housing prices have gone down recently. And I suspect I know the reason – all these damned people around me selling their houses for low prices! By selling their houses for low prices, they are causing the externality of making my house worth less, since potential buyers don’t seem willing to pay extravagent prices for my house when they see all these other houses around me going for low prices.
There’s something not very pragmatic about the laissez faire approach to home selling.
So, I think what we really need is a governmental agency to prohibit people from selling their houses for low prices. This would prevent that bad externality from occurring – if the government agency requires everyone to sell for high prices, then there would be no externality to causing prices to drop in the nieghborhood by selling for low prices. It’s all perfectly justified!
July 9th, 2009 at 10:52 am
I think it is important to note that it would be perfectly reasonable for a financial risk-regulator to consider how home foreclosures affect the value of neighboring homes. That is really a form of externalized risk, and it specifically goes to calculating systemic financial risk (due to declining home values potentially further increasing defaults and foreclosures, setting off a downward spiral).
Again, that is not a consumer protection argument per se, but it does make sense to account for these neighborhood affects in setting mortgage regulations.
July 9th, 2009 at 11:02 am
The neighbors who lose 10% of their homes’ values because of foreclosures only gained that 10% because of the ridiculous mortgage system, which brought new buyers into the market.
That’s not quite accurate, as I understand it, meaning the value of their homes may well end up lower as a result of this process. In a nutshell, that is because given neighborhoods are subject to negative feedback mechanisms which can be set off by foreclosures.
But of course Al has a point: all this doesn’t motivate trying to make prices high per se. What it does motivate, however, is trying to help keep price trends relatively stable over time, or at least trying to minimize the role the financial industry might playing in destablizing price trends.
July 9th, 2009 at 11:12 am
Is there any problem Matt doesn’t think should be solved by well-intentioned government agencies or additional taxes on things he finds objectionable?
July 9th, 2009 at 4:28 pm
There sure are a lot of NIMBY trolls here. I would love one of these people to actually *explain* why a consumer protection agency is a bad thing.
I noticed a few of them actually claiming (without any justification) that this is equivalent to re-inflating the bubble, which is completely ridiculous. If anything, a consumer agency meant to keep the lenders honest would do exactly the opposite, since it was dishonest practices that inflated the bubble in the first place.
I would imagine that some of the objections are also coming from reflexive anarchist/libertarians, who, despite the past 30 years of the laissez faire failings started by Regan and maintained by the GOP, still believe that government agencies really are the enemy.
July 9th, 2009 at 5:04 pm
bugmenot I think most of the objections are not that a Financial Consumer Protection Agency is bad, but that it shouldn’t be confused with a Home Value Protection Agency.
Of course, you gotta admire the dashing imprecision of a post where the author quotes a scenario approvingly, notes that he doesn’t agree with the entire scenario, but that the unidentified part he does agree with proves his point. This sentence, in particular, is genius: “Still, I think the main point holds, there’s perfectly good reason to regard the viability of these arrangements as a matter of general social concern and there’s also good reason to want people to err on the side of caution.” Is that some vintage bullshit, or what? Rock on, Matt!
July 9th, 2009 at 6:27 pm
I like this Mike at Rortybomb character. I enjoyed his musings on the nature of crime. What is crime?
I’ve always believed that 92.3% of all crime falls into the category called “perfectly legal.” Wall Street, which I consider the epi-center of the world’s criminal activity, operates, according to government authorities and media-types like the Wall Street Journal, predominantly on the up and up.
As for the crackhead, as long as he takes only my cash and not my wallet when he shakes me down -I got no problem with him.
July 9th, 2009 at 7:03 pm
The decline in property values in houses close to foreclosures is one of several thousand good reasons for why mortgage lending practices should be regulated in the public interest.
Of course, the federal government was intensely regulating mortgage lending — it was just regulating it in what turned out to be the wrong direction: toward laxer credit standards in order to increase lower income and minority homeownership.
July 9th, 2009 at 7:58 pm
This isn’t an FCPA problem, it is an educational system reform problem. Stop tying school funding to the wealth of the local neighborhood and people might stop treating housing location as a positional good. Magnet schools might help too, if the kid is as involved in his/her academic success as the parents.
Except that the real issue isn’t that the parents want to send their kid to a neighborhood with a better-funded school. They want a neighborhood with better neighbors, and a school with better students. It’s the quality of students at the school that is the issue moreso than the quality of funding.
July 9th, 2009 at 8:25 pm
#29 Steve is right that Congress encouraged the banks very strongly to make sub-prime loans for “social” reasons.
I am suffering from this mortgage crisis not because of that in a direct way because I made a 20% cash down-payment – to satisfy several prior commenters’ criterion – but still find my home way underwater.
The H4H program started last year by the FHA and FDIC (now called the Obama Plan for PR reasons) doesn’t help at all because reducing my interest rate temporarily does not get me above water. It has helped very few people because it did not address the right issues IMHO (and in many experts’ HOs.)
Likely I will end up being forced into a short sale: the bank will lose a bunch of money; the owners of the securitized mortgages will lose a bunch of money; I’ll lose my credit rating; my neighbors will lose value on their homes; and no one except the new buyer will win.
I try to tell the bank – CW, now BAC: Reduce my mortgage and interest rate to the current market value (that is “mark-to-market”); I’ll eat the down payment.
I get no response because “they are very busy” even after however many hundred million dollars BAC received from us taxpayers.
Turns out I can afford my mortgage payments but I am not paying them because
if I make the payments, the bank will not talk to me at all.
This so irrational. But what isn’t in Washington?
July 10th, 2009 at 11:37 am
Why I got this article late, I don’t know. In response to the home values, the older neighborhoods only increased in value due to us crackheads improving the properties while brand new neighborhoods suffered from in house financing from the developers approving the crackheads to move in. Part of this article points the finger at the current vast amount of crackheads. If that’s the objective, then don’t you think you would need drug dealers. Holding up the little baggies were the brokers,lenders and realestate agents. I find it impossible to accept that millions of people used individual thought waking up one morning deciding to smoke crank. Enforcing consumer protection is necessary since brokers, lenders and realestate agents choose against their own moral employed judgement and decided to hang out in front of school yards waiting to get the children addicted.