Why fixing the flaws in the current system and increasing funding is a better approach than creating a new tax credit
The incoming Biden administration has made improving racial equity a pillar of its domestic policy agenda, and appropriately so. There is a compelling argument that ending historic economic and racial inequity should start with housing, specifically down payment assistance. With home equity accounting for a quarter of total U.S. household net worth, policies that significantly narrow the 30-percentage point Black-White homeownership gap, which is as wide as it was in 1890, could also help narrow a vast racial wealth gap.
In 2019, White families had 8 times the wealth of Black families ($188,000 vs. $24,100), and five times more wealth than Hispanics ($36,100). Extending sustainable homeownership opportunities to more people of color would not only improve racial equity, it would also be good for economic growth.
According to new research by Morgan Stanley, equalizing Black-White homeownership rates over the next 10 years would create more than 5 million more homeowners of color, generate nearly 800,000 new long-term jobs, and raise up to $400 million in additional tax revenues relative to current trends.
A growing need for down payment assistance
More than twice as many Black families (19%) as White ones (9%) have zero or negative net worth, making a down payment on a first home an insurmountable obstacle for many minority families. This is why a centerpiece of the campaign’s homeownership agenda is a new, refundable and advanceable down payment tax credit of up to $15,000, which would be available to targeted first-time homebuyers at the closing table.
However, as the campaign transitions to the Biden-Harris administration, the incoming team needs to address significant operational and design challenges before such a tax credit is sufficiently ripe for consideration by a narrowly divided Congress. Chief among these is how to operationalize the advanceable feature of the credit, which is akin to asking the IRS to deliver individual tax refund checks to tax filers on a date of their choosing, relying on obsolete technology and inadequate staff resources.
Another unresolved issue is how to integrate a new Biden-Harris tax credit into the existing network of more than 2,500 active programs in more than 1,300 public agencies currently offering down payment assistance (DPA) at the local, state, and national levels, totaling more than an estimated $1 billion a year.
DPA has become such an integral part of the state housing finance agency (HFA) business model that in 2019, nearly three-quarters of all the single family mortgages they funded carried down payment assistance. The typical agency financed nearly 3,000 loans that averaged about $7,200 in DPA, amounting to about 4.5% of the average home price.
While there is some overlap with state agency data, FHA mortgage lending has become increasingly reliant on DPA as well. In fiscal year 2020, about 40% of all FHA purchase loans carried some form of down payment assistance, helping more than 325,000 families. At slightly less than a quarter, gifts from eligible family members were the largest source of DPA, followed by a government source at 15%, which supported more than 126,000 families.
Another indication of the mainstreaming of down payment assistance is the secondary market’s growing comfort with DPA as reflected in Freddie Mac’s dedicated landing page containing materials to keep originators up-to-date on available down payment and closing cost assistance programs for possible use in conjunction with its affordable housing lending products.
The Biden administration has rightfully decided to tackle this problem, but has chosen an instrument that may not make the most sense. In this brief, I explain why fixing the flaws in the current system, which would expand regional and national lender participation, and increasing available funding is a better approach than creating a new tax credit.
As commonplace as DPA has become, this industry suffers from three major problems: A patchwork of different program structures and borrower requirements across agencies and jurisdictions, which raises the costs and limits the interests of regional and national lenders from scaling up their DPA activities.
Second, most DPA programs lack transparency, with few state agencies and national providers reporting detailed performance of DPA-linked mortgages compared to non-DPA loans.
Finally, there are not nearly enough dollars to make a dent in the racial homeownership/wealth deficit. Fortunately, it is possible to generate additional funding to meet current and future needs without an act of Congress thanks to the coming expiration of a pay-for for an expired Great Recession-era program. The remainder of this article lays out a blueprint for achieving these ends.
Building Back Better
Currently, state agencies employ a plethora of program rules, and sources to fund their DPA programs including, among others, bond premiums, secondary market loan sales, internal resources, state sources, and recycled bond proceeds, which raises costs and limits lender participation across agency programs.
Greater standardization and transparency is achievable by requiring the gateways to the secondary market —FHA/Ginnie Mae, and Fannie Mae and Freddie Mac — to adopt similar rules and reporting requirements for loans that they guarantee and securitize that carry down payment assistance. The responsible parties here are the Secretary of Housing and Urban Development and the Director of the Federal Housing Finance Agency, who regulates the GSEs.
HUD and the GSEs already prohibit the seller, real estate agents, builders and developers who have a financial interest in the transaction from contributing DPA to a borrower, and these restrictions should continue. Current HUD policy defining eligible contributors to DPA should also remain in place and extend to the GSEs. These include a member of the borrower’s family; the borrower’s employer or labor union; a close friend who has “a clearly defined and documented interest” in the borrower; a charitable organization; and, a governmental agency or public entity that has a program providing homeownership assistance to low or moderate income families or first-time homebuyers.
There is a chokepoint in current practice from the outgoing administration’s overly restrictive interpretation of current federal law that requires down payment assistance connected to an FHA loan to be a “gift.”
With gift defined as “contributions of cash or equity with no expectation of repayment,” the question is the extent to which governmental sources of DPA can “premium price” an FHA loan by bumping up the note rate in order to replenish their pool of borrower upfront support directly, or indirectly, through secondary market sales. (A premium-priced loan sold into a lower-coupon Ginnie Mae security generates a profit on sale that can help pay the DPA provider.)
Legitimate regulatory concerns about this practice arise because borrowers may not always realize that they are the ones financing the gifts from their lenders over time through higher loan payments, which is why guardrails are required.
However, the incoming HUD team should not ban premium pricing outright as the outgoing administration favors. Instead, it should revert to an Obama-Biden ruling that DPA from a government source can constitute a true gift under four stated stipulations. These are that: (1) the down payment proceeds come out of a Ginnie Mae secondary market transaction; (2) the borrower signs no separate security instrument for the DPA; (3) the borrower can prepay or refinance the loan at any time without penalty; and, (4) there is no expectation of repayment of the DPA.
Down payment assistance and default risk
HUD also argues that down payment assistance increases default risk and taxpayer exposure, which my research has shown not to be true after accounting for borrower attributes, including demographics and credit scores, and local market conditions. Considering these variables, my colleagues and I found receipt of DPA was not significantly associated with default risk.
Even without controlling for these factors, HUD’s argument that DPA provided by family members historically outperform loans with government-sourced aid is scarcely the case today. Moreover, clamping down on government-sourced DPA alone could have disparate racial impacts because borrowers of color are much less likely than their White counterparts to have sufficient family savings or wealth to draw upon for a down payment.
The geography of DPA
HUD has also sought to rein in the few national DPA programs on performance grounds, arguing that DPA providers like state HFAs, who operate in a single jurisdiction, have lower default rates because they are more politically accountable and have stronger oversight. The problem here is that there are no provider-specific public performance data either for individual state-based or national programs to back up this assertion.
Rather than providing monopoly control to state HFAs, the new HUD leadership should level the playing field by adopting loan-level reporting requirements for all DPA providers, whether they operate statewide or nationally, with disclosure of borrower attributes, pricing, and loan performance. Rather than restricting the geographic coverage of DPA providers, HUD should hold accountable poor performers whoever they are.
While administrative actions that clear the underbrush discussed above should expand lender take-up and increase the pool of available down payment assistance, significantly reducing the massive minority homeownership and wealth gaps will take far more resources than are potentially available.
Fortunately, working with a motivated FHFA director, the Biden administration could shake loose several billion dollars in new DPA resources using existing authorities by taking advantage of an existing law that is set to expire in October 2021. That law, the Temporary Payroll Tax Cut Continuation Act of 2011 (TCCA), imposed an annual 10-basis point fee that would remain in effect for 10 years on new single family mortgages purchased or guaranteed by Fannie Mae and Freddie Mac to pay for a two-month extension of the 2010 temporary payroll tax cut.
TCCA prohibited the GSEs from passing this fee on to lenders, borrowers, or investors, instead requiring them to absorb the cost as a reduction to their respective bottom lines. Instead of letting the fee expire on Oct. 1, 2021, as the law requires, Congress could generate an estimated $5 billion in additional DPA and related affordable housing resources by extending and repurposing the fee, at little cost to the federal government, and without increasing mortgage rates.
While getting any new legislation passed is a heavy lift, the odds of reaching a bipartisan deal to tweak TCCA should be significantly greater than coming together on a new, advanceable and refundable, down payment tax credit.
However, should there be no legislative path forward, the new administration should explore whether existing legal authorities would permit a new FHFA director to require the GSEs to keep the 10 bps fee in place, and redirect the revenues to support a more robust duty to serve underserved markets regime. An obvious limitation of the administrative route is that all of these new affordable housing resources would be limited to supporting GSE activities, and not be a source of additional DPA funds to FHA/Ginnie Mae financed homes.
Legislating changes in TCCA would also make it easier to create national standards, disclosures and reporting requirements for all DPA-linked purchase mortgages sold into the secondary market, and not just those bought or guaranteed by the GSEs. These standards would require lenders and DPA providers to adopt a series of checks and balances in both underwriting and education requirements to maximize borrower success.
These include things like pre purchase mandatory lender-funded housing counseling; tighter debt to income ratios, credit score minimums set above the floors of the current FHA guidelines, and reserve requirements to insure the ability to survive a short-term interruption in income. Standards like these can be established using best practices applied by current providers.
Done right, we can change the paradigm of home ownership opportunity due to lack of down payment while minimizing incremental default risk. Getting this right could be a game changer in wealth creation especially for minorities and other demographic segments that are at present denied access to homeownership.
While working to get it right, however, we must recognize that DPA is just one part of a larger interconnected housing ecosystem. Unless we take actions to increase the available supply of starter homes whose prices continue to rise faster than other market segments, by juicing demand, an infusion of additional DPA will only further fuel this inflationary spiral that benefits existing homeowners to the detriment of those seeking to buy their first home.