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Housing Bankruptcy Ripple Effect

posted by Adam Levitin

We're starting to see the bankruptcy ripple effect of the housing crisis beyond the housing and financial services industry. Now municipalities are being forced to declare bankruptcy because property tax revenue has dried up while foreclosures have imposed significant strains on municipal resources.

While moral hazard concerns are a real issue for any government aid to borrowers or lenders, its worthwhile remembering a major exception to moral hazard--third-party costs. As Larry Summers summarizes: When the fire department rescues people who start fires by smoking in bed, it creates a moral hazard for in-bed smokers. But no one gets exercised about moral hazard, in part because we know that fires can spread and burn down neighbors' apartments in "contagion" fires and that the in-bed smokers won't take care to insure their neighbors. That's what we're seeing in foreclosure crisis--mounting third-party costs to neighbors and local government. If the municipal government goes bankrupt, it affects everyone in the community--indeed, those who had to relocate because of foreclosure escape this consequence. Foreclosure is a real problem for everyone, not just those who get kicked out of their homes or whose investment portfolios take a hit.


I think that the housing crisis is going to do a lot of damage to the economy - but I wouldn't be so quick to ascribe Vallejo, California's problems to decreased revenues. Falling revenues are only the last straw on a camel's back that was loaded down with firewood just waiting on a spark.

Vellejo's problems stem from union contracts and pension obligations that were unsustainable - even if the economy had kept perking along. Of course, since they are going to be seeking to reject union contracts in their bankruptcy, they aren't going to say that they filed their Chapter 9 for that purpose. But they did.

The New York Times article glosses over a long history of fiscal irresponsibility in Vallejo:


I haven't checked each of the facts listed below, but they are in keeping with what I've read about Vallejo's financial woes:

* 87% of the annual budget of Vallejo is spent on employee salaries and benefits.

* The present value of employee pension benefits is over $135 million

* Union contacts promise employee pay raises and minimum staffing requirements (no lay offs allowed regardless of cities financial position)

* For every dollar paid to a public safety employee another $.28 is added by taxpayers to the employees pension plan (does not include amounts also added for social security, health insurance, vacation time, sick pay, family time off, dental, disability, etc)

* In 2007 in Vallejo, 98 firefighters made more than $100,000 and 10 made more than $200,000.

Those numbers - if you know anything about municipal budgeting - are mind blowing.

It should also be noted that the Vallejo school district was essentially bankrupt in 2004-5 - during the height of the boom, and the state had to take it over:



I'm not anti-union. And I don't think I'm one to minimize the effects of the foreclosure crisis. But Vallejo's local government was a poster child for fiscal idiocy, and that's the main reason they had to file the 9. Falling revenues may have accelerated their filing by about a year, but that's all. The writing - in indelible red ink - was on the wall.

I'd second AMC's statements - Vallejo, to put it bluntly, is a basket case, a sort of perfect storm of incompetency that would have made life tough in a good economy, let alone this one.

sorry, but I think this is utter nonsense. Municipalities could be managing the situation for the benefit of the community, but they are NOT. Why are they not fining house owners into oblivion who are not maintaining the properties? If that doen't work, pass ordinances allowing them to take over properties that are found harmful to community interests.
More importantly, the simple problem Bubble states face is housing prices are so inflated people can't afford to live in them, let alone buy them.
It's sad no one is referencing this problem from the perspective of young adults, ready to buy into our communities but already so over-ladened with debt they wouldn't qualify under old lending rules even if allowed a zero down opportunity.
To me the answer is simple - houing prices must retrace to historical growth rates & any resolution to the woes of owners must be addressed on an individual basis. This latter point is not nearly so difficult as it's being presented.

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