Seller Financing: Contracting Out of the Lemons and Moral Hazard Problems When They May Co-Exist

Abstract

Quality problems that are known to the seller of an asset, but will become known to the buyer only after the purchase have the potential to frustrate voluntary exchanges. When the problem is subtle or confounded by the extent of buyer inputs, requiring risk-sharing by the contracting parties, both parties would benefit from a mechanism, such as seller financing, which not only credibly signals to the buyer the veracity of the seller’s representations about the asset (s)he is trying to sell, but also offers the seller sufficient protections against the potential that the buyer may engage in post-sale opportunistic behavior about the maintenance of the asset. We analyze one-time-only mortgage contracts in the National Association of Realtors' Home Financing Transaction database for 1984-1996, (data not collected outside this period), and find empirical support for seller financing as an asset quality signal and, separably, as a mechanism for providing credit when conventional credit sources are tight. We also point out the broad, but not well-acknowledged, reach of seller financing, including the sub-prime loan debacle, the earnout mergers or reverse annuity mortgages, which are inherently embedded with both asymmetric information about the quality of the relevant assets and moral hazard about the asset acquirer’s post-purchase maintenance.