TCS Daily

Down Payment Debate

By Kevin Hassett - May 10, 2004 12:00 AM

Free markets are so successful because individuals and businesses constantly mutate in response to changing economic conditions. Sometimes the process can lead to very surprising and interesting developments. Just as a visit to the Galapagos Islands can present one with bizarre creatures, inspection of odd corners of the economy can lead to thought-provoking discoveries. I recently noticed such a case that has positively fascinating economics. A strange regulatory environment led to stranger mutations, a set of not-for-profit companies that provide large cash gifts to citizens, and angry government officials who want to shut them down.

Policymakers have for many years sought to stimulate home ownership. For medium and high-income individuals, the primary stimulus is the mortgage interest deduction. For low-income individuals, a number of additional programs have sought to reduce the costs of home ownership. Perhaps the largest of these programs is the Federal Housing Authorities 203(b) insurance, which insures lenders for loans to qualifying individuals.

While this program has successfully made private capital available to low-income individuals, the requirement that buyers have a downpayment of at least three percent of the purchase price of the home has created an unusual market. Not-for-profit enterprises have emerged that provide home buyers with gifts to cover their down payments. These "down payment assistance program" (DAPs) gifts are sourced directly or indirectly to sellers. While one can readily understand why a recipient might accept a gift of down payment assistance, it is less easy to understand why a seller might desire to pay it. The public policy discussion to date appears to rely upon a less-than-charitable view of the seller's motivations. In fact, however, two competing views of the economics of DAPs exist that have different testable predictions. Let's have a look.

DAP Theory I: Free Riding (or "direct payback")

The key to developing a theory of DAPs is to evaluate the possible motivation of the seller. The "free riding" theory of seller motivation is fairly straightforward. Consider, for example, a seller who has a house for sale for $100,000 who has found a buyer who does not have access to a down payment. Suppose also that the market is fairly thin, and that the seller may fear that if he loses this buyer he may have to wait a significant period before finding another willing buyer. The seller may decide to offer down payment assistance in this case.

The assistance could have the following form. The seller could give a gift to the buyer of $3,000, and then sell the house to the individual for $103, 000. In this case, the effective sales price will be the same, yet the down payment rules will have been avoided. This theory should be thought of as the "free riding" theory because the difference between this transaction and a standard one is that the mortgage is for $100,000 rather than $97,000, and the guarantor of the mortgage would stand to lose more money should the buyer eventually default on the loan. In a default, the lender might acquire the house and only be able to sell it for $100,000. Had the loan been a traditional loan with a $3,000 down payment, and then the lender would have some risk-reducing cushion. With the DAPs under the free riding hypothesis, there is no real cushion for the lender.

Notice that this requires that the property assessment process have enough error in it that this game can go on below the radar of the lender. Given the relatively low percentage of the down payment, such an assumption seems plausible.

Of course explicitly doing this could be illegal, but to get a buyer to buy a house worth $100,000 the seller would list it at $103,000 including the down payment assistance that they will provide.

This view is clearly a concern to policymakers, since the federal government bears the risk through the FHA of many of the loans that receive down payment assistance.

DAP Theory II: Equilibrium Selection (or "indirect payback")

Since DAPs are often targeted towards low-income individuals, it may be that the economics of neighborhoods becomes relevant. If so, then an alternative to the free rider theory becomes plausible. DAPs may be used by builders to lure attractive buyers to "bad" neighborhoods in order to start the process of gentrification.

The following stylized example illustrates how this might work. Suppose that there are two potential homebuyers, Tom and Bob, and two neighborhoods, uptown and downtown. Downtown is a very risky neighborhood with a high crime rate and low property values. Uptown has low crime levels and high property values. Tom and Bob face the following payoffs that depend on their neighborhood choice.

In the box, the first entry is the payoff to Bob and the second number the payoff to Tom. If, for example, Bob moves uptown and Tom moves downtown, then Bob gets $10 and Tom loses $100. If both Tom and Bob move downtown, then the neighborhood will gentrify, and their property values will increase sharply. In the example, their payoff is positive one hundred dollars each. If only one of them moves, however, then the neighborhood will not gentrify, and the sole mover will experience the pain and discomfort of a failed move, measured in the box as a loss of one hundred. If either of them purchases a house uptown, then they can expect a modest gain of 10 dollars.

This simple game may well accurately characterize the economics of marginal neighborhoods. Notice that the problem with the game is that it has two possible equilibria: both move downtown or both move uptown. These are equilibria because it would not pay for either person to move if they found themselves in that state. Both individuals are clearly better off if they both move downtown, but this may not occur because of the fear each may have about the actions of the other. Clearly, Tom and Bob would both be better off if we introduced a commitment device into the game that would guarantee that the best equilibrium occurs. Down payment assistance is a good candidate for a commitment device, since the seller could potentially capture some of the surplus associated with gentrification.

For example, a seller might purchase up a large amount of real estate in a "bad" neighborhood, and then subsidize with down payment assistance in a large enough number of purchases by "good" buyers that the neighborhood becomes gentrified. In this case, both the buyers and the seller are better off, because the best equilibrium has been supported by the DAPs.

Testing the Two Theories.

From the point of view of public policy, the two theories have dramatically different implications. Under the free rider theory, sellers are passing risk along to taxpayers that may eventually be quite costly. If equilibrium selection is correct, then down payment assistance is a useful tool to aid gentrification of troubled neighborhoods. Interestingly, the two theories have dramatically different implications concerning the relationship between transaction prices and future price movements. This section draws these differences out, and performs a simple test of the two theories against each other using a large database acquired from HUD.

Under the free rider view, the current transaction price is higher than market value, since the transaction price includes the direct "payback" for the gift. Accordingly, one might expect to see housing prices in regions that relied heavily on DAPs in the past to increase more slowly over time than prices in regions that did not rely heavily on DAPs in the past. This will occur both because the prices in regions that used DAPs in the past will be inflated by the direct payback, and because prices in regions that did not use DAPs in the past have yet to include the payback.

Alternatively, under equilibrium selection, the opposite should be true. As long as gentrification does not typically happen all at once, then prices should increase faster than the sample average in areas that rely more heavily on DAPs.

These alternative views of the economic role of DAPs provide sharply different predictions. To assess which view is most consistent with the evidence, we gathered price data from the Department of Housing & Urban Development through a FOIA (Freedom of Information Act) request made to HUD's Office of General Counsel in late 2003. The 4,986,895 observations are an extraction from HUD's Single Family Data Warehouse (SFDW), (this particular extraction comes from Table idb_1 in the SFDW). This data is loan level micro data and contains most attributes collected at time of loan applications. Additionally, it is updated with loan performance over time.

In a work in progress we are exploring a number of other questions, including the impact of DAPs on default rates, but here we explored the impact of past down payment assistance grants on the future behavior of real estate prices in order to shed light on the two competing theories. Specifically, we aggregated the data to the five-digit zip code level and looked at the behavior of average prices after 1997 in two subsamples. The first set were those that make up the "treatment" group of zip codes that had a five percent or higher share of sales that received down payment assistance. The "control" group consisted of those counties that had a lower than five percent share of sales with down payment assistance. The results are contained in the following table.

As can be seen, the percent increase in property prices after 1997 for home counties that relied heavily on DAPs was significantly higher than the increase in the control group. This difference is highly statistically significant, and suggests that equilibrium selection may play an important role in determining the recipients of down payment assistance.[1]

Policy Implications

While this work is preliminary, it is an interesting exercise to assume that equilibrium selection is important and then consider the policy implications. This is especially true in light of the fact that some have argued recently that HUD should eliminate the downpayment requirement altogether.

From a strictly theoretical perspective, the elimination of the downpayment requirement will not preclude developers from using DAPs to coordinate gentrification. However, it may be that absent the down payment requirement, that developers will seek other methods to induce "good" families into "bad" neighborhoods, and that down payment assistance providers will see a significantly reduced supply of down payment assistance gifts from sellers, and that the trade-off between good and bad neighborhoods will be significantly altered by the elimination of the downpayment requirement.

Under current rules and equilibrium selection, a hypothetical "good" buyer with an excellent job but no downpayment has only one choice. He cannot buy in a "good" neighborhood because he does not have the downpayment. He can buy a home in a "bad" neighborhood from a developer who provides down payment assistance and promises to continue to do so to other future buyers. This action might seem attractive because the down payment commitment makes the belief that the neighborhood will improve plausible.

On the other hand, if the downpayment requirement is removed, then a "good" buyer will have two choices. He can either buy in a "good" neighborhood without an incentive from the seller, or he can buy in a "bad" neighborhood and receive some kind of incentive. Given this choice, it may be that it is much more difficult to support gentrification as an equilibrium strategy, and that universally waving the down payment requirement may slow the process of neighborhood improvement significantly.

The author is Director of economic policy studies, the American Enterprise Institute. This research was partly funded by the Nehemiah Corporation.

[1] In a work in progress, we are attempting to see if this pattern in the price data is spurious by controlling for numerous other factors that may predict future price movements. Our preliminary findings continue to indicate that prices increase faster in high-DAP counties than they do in low-DAP counties.


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