Eric Posner, a provocative new addition to the Volokh Conspiracy who has written on the War on Terror, foreign relations, and financial affairs, recently blogged this defense of mortgage rate readjustments (emphasis added):
The basic problem posed by the housing crisis is that millions of people find themselves with negative equity and rationally abandon their homes. Banks have trouble seizing, maintaining, and selling these houses, and bankers will tell you (anyway, they’ve told me) that the rule of thumb they use is that a foreclosed house will lose fifty percent of its value. I am unaware of any studies that prove that this figure is correct but the anecdotal evidence is powerful. In some communities, abandoned houses become havens for drug dealers and squatters who strip away wiring and whatever else might be valuable in the house. The derelict houses reduce the value of neighbors’ houses, who then can be plunged into negative equity themselves, causing them to abandon their houses as well, leading to further degradation of the neighborhood, in a vicious spiral.
From a theoretical perspective, there are really two problems. First, bankers and mortgage holders are unable to negotiate contracts that provide for an automatic mortgage modification in the event that the value of the house falls below the debt. An optimal, complete contract would provide for such a debt adjustment, but it seems likely that bankers fear that any such provision could be too easily gamed, and so they prefer to renegotiate ex post if necessary or simply swallow the costs by having a policy of automatic foreclosure. Second, bankers and mortgage holders have no incentive to take into account the possible negative effects of mortgage default on neighbors.
As I have argued in earlier posts, the solution to such a problem in principle is mortgage modification. A banker does better by voluntarily reducing principal and interest than by foreclosing; however, big banks have traditionally refrained from renegotiating, perhaps because the transaction costs are high (smaller banks have traditionally agreed to renegotiate, by contrast). In the current climate, big banks are rethinking their earlier policy, but in any event it is hard to renegotiate with someone who has abandoned his house and disappeared.
I don’t really have anything particularly insightful to say about the matter. Posner may be right about the efficiency of crisis-delimited government intervention in the mortgage market, though his fellow Conspirator Todd Zywicki disagrees. It’s the next part of Posner’s argument that really bothers me:
We have learned from this crisis that every mortgage imposes potentially serious negative externalities on third parties. When someone defaults and abandons his house, he causes harm to others. The law currently does not punish that person or try to deter him from what is essentially a kind of pollution (like abandoning a car in the street); any attempt to do that would be impractical. So in a second-best world in which wrongdoers cannot be punished for the harm they cause others, restrictions on the contracts that bring about this state of affairs may well be justified. That is what bankruptcy law has always done; mortgage modification is a further development in bankruptcy law that would be justified in crisis (and possibly even normal) conditions.
Economically minded people sometimes display a regrettable tendency to ignore the difference between indirect and direct effects and their moral implications. Is it merely “impractical” to punish those who abandon their houses? Are they really “wrongdoers” who would be punished in a perfect world? I don’t want to discount the possibility that Posner uses overly-strong language here merely to showcase the economics of the situation, but his language plainly assumes a moral and redressable wrong on the part of those who abandon their house.
The issue here seems to be the proper baseline. When my neighbor maintains his house and keeps his lawn in good order, my property value appreciates from the aesthetic gains. But in what sense do I have a right to that gain? It was not something I labored for, nor have I contracted with my neighbor for it. When my neighbor leaves he does not “steal” his manicured lawn from me – I never owned it in the first place. Nor is he responsible for the actions of the drug dealers who may light on the foreclosed property – they are individuals, fully responsible for their own actions. I have few legitimate claims on my neighbor’s property, the implications of demanding housing codes notwithstanding. Any benefits I accrue from his beautifying his own property are above baseline moral obligations.
The public property of the street imposes a higher baseline obligation. Since it is commonly “owned” for a specific purpose, all citizens have some obligation to respect the claims of their co-owners. If my neighbor leaves his car in the middle of the street, he impairs my use of the road. Posner’s attempt to place the argument for mortgage bailouts in an externality framework which could appeal even to libertarians does not work well. If we are intervene in mortgages, we will have to accept that we do so for pure efficiency reasons, not in redress of an “injustice” committed by homeowners.