Moral Hazard and the Costs of Foreclosure

Today the Boston Globe reports that the City of Boston will begin pressuring mortgage companies to maintain their foreclosed, vacant properties. Many of these deteriorating buildings are in violation of city ordinances, and when safety becomes an issue, the city is forced to assume the costs of boarding buildings up or—as in the case of one home—draining a backyard pool.

The costs of maintaining foreclosed properties can be thought of as a negative externality: an expense produced by the mortgage companies’ own behavior that is borne by someone else, in this case the citizens of Boston. To the extent that we blame the foreclosure crisis on the irresponsible practices of lenders who have ventured into the risky subprime market, we can say that these costs have been unfairly unloaded onto the city. Ideally, the banks should adopt lending practices that make foreclosure less likely and factor all the costs of foreclosure—including the maintenance of vacant properties—into their business plans.

Which brings us to the concept of moral hazard: the idea that people who are shielded from the risks of their own actions behave less responsibly. Moral hazard is often applied to consumer behavior. For example, one of the arguments against supplying health insurance is that it might encourage risky behavior and the unnecessary use of healthcare services. If everyone assumed all the costs of their health-related behavior (e.g. eating, smoking, and visiting the doctor) would they behave more prudently?

The proposed responses to the foreclosure crisis also bring up issues of moral hazard. For example, would a bailout of the mortgage lenders shield them from the consequences of their unwise lending practices and inadvertently encourage that behavior? (For a discussion of these issues, see the NPR story “Subprime Bailout: Good Idea or 'Moral Hazard?”)

The question of how policies encourage or discourage prudent behavior is a constant concern. In this case, Boston City Councilor Robert Consalvo will introduce legislation that would force mortgage companies to identify who is responsible for the maintenance of empty buildings, post contact numbers, and pay a $100 annual fee for each vacant property. It is unclear whether this plan would eliminate a moral hazard in the lending industry and promote more responsible lending practices, but at very least, the City of Boston is justified in redirecting the costs of maintaining vacant foreclosed properties back to the owners.