There's a front page story on CNN.com today describing the current rebuilding plan for New Orleans. I'm not going to describe the whole plan here, but instead focus on something I find strange:
Building levees capable of withstanding a Category 3 storm and creating a government-funded reconstruction corporation to buy out land and properties are pivotal to the commission's rebuilding plans, according to members of the urban planning committee.
Doug Meffert, co-chairman of the sustainability subcommittee, said it also will be essential that homeowners can be bought out at fair market value. [emphasis added]
The question I immediately ask myself: What is fair market value? To try to answer, I'm going to use an economist's favorite--and most dreaded--weapon of mass confusion: the supply and demand graph. Let's think about the market for houses in flood zones in New Orleans last spring, before the hurricane. At that time, most residents knew they lived below sea level but there were nice strong levies to keep the water back. But, there was also a possibility that the levies might break sometime--say if a big enough hurricane took direct aim at New Orleans. In other words, there was uncertainty about what the future value of houses would be after a hurricane. If the levies held, the value of houses would rise--demand would increase--because everyone would feel a little safer. If the levies broke, the value of houses would fall.
The graph on the right shows the situation--click for a bigger version. Before the hurricane residents were unsure whether the value of their houses would be high after a hurricane ('Demand if levies hold') or low (the line labelled 'Demand if levies break'). If a hurricane were to come through and the levies held, the market price for a house would be higher--'Price if levies hold.' If the levies were to break, the market price would be lower--'Price if levies broke.' Because people buying and selling houses in the area couldn't know for sure what would happen they based their decisions on their best guess. That would be somewhere between the two extremes--the 'Expected demand'.
So, back in the spring, the 'fair market value' of a house was based on buyers and sellers best guesses as to what might happen if a hurricane came through. But there was some uncertainy. In August, that uncertainty unfortunately resolved itself. Katrina came through and the levies broke.
Now the local governments are asking that homeowners be compensated at the 'fair market value' for the houses.
The subcommittee will recommend that the corporation buy out properties at full value minus what insurance pays out.
But what is the fair market value for the house? I'm sure the local governments, and the residents, have in mind the value of the house back in the spring. Unfortunately that is no longer the fair market value for the house. There is no longer any uncertainty. Even after the levies are rebuilt, houses in the area will be priced lower. Future houses built in these areas will have to absorb a discount based on the realization that not all levies are hurricane-proof. And, I would venture a guess that houses in similar areas that didn't happen to flood are going to absorb a downward price adjustment also. Living in a flood-prone area is a gamble. Sometimes gambles are won, sometimes they are lost. Unfortunately, in this case, the gamble was lost. Now the question becomes, who pays for the losses? The gambler, or the innocent spectator?
