A few weeks ago, President Barack Obama signed legislation extending an $8,000 tax credit for first-time home buyers. The refundable tax credit, available even if a family has no taxable income, will enable many more buyers to close on a home. But it also could bankrupt the Federal Housing Administration (FHA) and, by doing so, damage an already weak housing market.

The tax credit was put in place as part of the stimulus package signed into law earlier this year. Initially, it was available only to first-time buyers with a combined income of $150,000 or less ($75,000 for individuals). Approximately 40% of all first-time buyers used the credit in 2009, so extending it was strongly supported by real estate brokers, home builders and their congressional allies.

The extension the president signed makes the credit available to first-time buyers, but also to people who have owned a home for at least five years. In addition, it raises the maximum income for a qualified buyer to $225,000 a year for couples and makes the credit available until mid-2010. (It had been set to expire at the end of this month.)

The problem is that the FHA insures mortgages of homes below certain price levels with such a low down payment that it can be funded solely by the refundable tax credit. And, as we’ve seen in the recent housing crisis, buyers with no skin in the game are more likely than others to default on their mortgages when the value of their home falls below their mortgage balance.

Here’s how the credit allows buyers to avoid putting their own money at risk. Suppose a couple making $60,000 annually buys a home worth $200,000. They can get an FHA-insured loan if they put down 3.5% of the purchase price, about $7,000. The couple will also need to come up with another $1,000 in closing costs, for a total of $8,000. The couple can either dip into savings or borrow that money from relatives or somewhere else on a temporary basis.

After closing, the couple can quickly obtain the $8,000 refundable tax credit to pay off their temporary loan (or replenish their savings). In effect, they will have bought a home without putting any of their own money at risk. Owners who don’t sink their own money into a house are much more likely to default on the mortgage.

The FHA already is facing a rising number of serious problems on its insured mortgages. Last week the agency reported that its cash reserves dropped to 0.53% of the $685 billion of total loans it insurers. This is well below the 2% federal law requires the FHA to have in reserves.

Beyond these reserves, the FHA has roughly $28 billion in a capital surplus fund, established by Congress to absorb losses on insured mortgages over the next 30 years. With the reserves and capital in hand, agency officials believe they have enough cushion to avoid needing a federal bailout. But a recent government audit concluded that the FHA would run out of money in 2011 and need a federal bailout if we have a protracted recession.

The deteriorating quality of the FHA’s mortgage portfolio is a critical challenge to the housing market and the federal budget. By the end of next year, the FHA’s portfolio is projected to rise to $1 trillion. Currently, over 20% of all new home mortgages are insured by the FHA.

Meanwhile, the tax credit for first-time home buyers is expected to cost the Treasury approximately $15 billion in 2009—more than twice the projected cost when Congress approved the stimulus package. Some of the cost overrun is due to fraud. At least 19,000 filers who claimed $139 million in tax refunds under this credit did not actually buy a home, according to Treasury officials. In addition, 74,000 filers claiming a total of $500 million in refunds seem to already have owned a home.

We all want to help first-time buyers acquire homes and support the depressed U.S. housing market. Without real down payments, however, new homeowners are likely to default on their mortgages, and the FHA will probably need a taxpayer bailout.

The Obama administration should increase the requirements to qualify for an FHA-insured mortgage. In addition to the 3.5% down payment, the administration should also require that buyers put down at least half of the tax credit they will receive for buying the home.

Mr. Pozen, chairman of MFS Investment Management and senior lecturer at Harvard Business School, is the author of “Too Big to Save? How to Fix the U.S. Financial System” (Wiley, 2009).

That essentially removes one of the private-sector checks in the system, he says.

Individuals who chase the higher yields offered by weaker banks could be taking an unforeseen risk. If the bank fails and is acquired by another bank, the principal invested will be protected, but the acquiring bank can cut the interest rate offered to market rates, the FDIC says.

Here is how securitization works (or used to work). A bank creates a trust, which acquires long-term subprime and other mortgages with money borrowed by the trust issuing short-term commercial paper. This paper must be resold every 60 or 90 days to take advantage of the lower interest rates on very short maturities. However, since the trust’s assets and liabilities remain off the sponsoring bank’s balance sheet, they are relatively opaque.

Bank sponsors could keep these trusts off their balance sheets as a result of certain accounting rules that emerged after the Enron fiasco. When Enron set up off-balance sheet trusts in the 1990s, it followed the accounting rules of the time by purporting to have an independent investor hold at least 3% of the voting equity. Critics claimed that the company violated the 3% rule; they also argued that independent investors should have larger stakes in the trusts to assure that they were not controlled by their sponsors.

In response, the Financial Accounting Standards Board (FASB) introduced new rules for enabling a trust sponsor to keep the trust off its balance sheet. Unfortunately those rules set the stage for today’s liquidity crisis.

Under the new FASB rules, you looked first at whether any investor held 10% or more of the trust’s voting equity. If so, the trust had to be placed on the balance sheet of the investor, if any, with voting control of the trust. But almost every type of trust used in the subprime crisis – e.g., SIVs and conduits – made sure that no one ever held more than 2% of the trust’s voting equity.

Next you looked at what party held the majority of the trust’s risks and rewards, to see if that party had to put the trust on its balance sheet. But the risks and rewards of these trusts were widely dispersed. And so, the trust appeared on no one’s balance sheet.

Nevertheless, under FASB’s revised rules, the bank sponsors were supposed to disclose any “significant” interests they had in these trusts, including formal or informal obligations to buy up the short-term commercial paper if it could not be remarketed every 60 or 90 days. These disclosures were thin until November of 2007 when HSBC became the first large bank to take on its balance sheet billions of dollars of troubled trust assets and associated liabilities.

In limiting their disclosures, the sponsoring banks made judgments that their remarketing obligations were contingencies unlikely to be drawn upon. The trusts were also viewed as low-risk investments by the rating agencies, which were paid by the sponsoring banks to issue AAA ratings to the senior securities sold by the trusts. Neither the banks nor the rating agencies fully appreciated the vulnerability to liquidity risks inherent in a trust with a mismatch between long-term assets and short-term liabilities.

So what should be done? First, FASB should again revise its rules to allow a sponsor to keep a trust off its balance sheet only if an independent party has sufficient voting equity to fund the trust’s normal operations – presumptively at least 10% – and that party has a substantial role in the governance of the trust.

Second, this large holder of the trust’s voting equity should have the right to select a rating agency for the trust and negotiate a fee arrangement with the agency. The rating process needs to be driven by an investor with a significant stake in an accurate rating, not the sponsor marketing the trust.

Third, the FASB and the SEC should be more specific about the disclosure requirements of trust sponsors with formal or informal obligations to buy up the trust’s unsold debt securities, especially if the long-term assets of the trust are mismatched with its short-term liabilities. The sponsor should disclose the nature of such obligations, as well as the size, quality and geographic concentration of trust assets. If there is more than a reasonable possibility of consolidating the trust over the next year, the sponsor should also disclose the financial impact of a possible consolidation.

The market for securitized assets can revive if trust sponsors make these disclosures and an independent holder of substantial trust equity is given some governance powers. Under these conditions, FASB can safely continue to allow bank sponsors to keep the trusts off their balance sheets – a necessary step lest we go back entirely to banks holding mortgages to maturity and lose the increased funding available for home purchases generated by the securitization process.

Mr. Pozen is chairman of MFS Investment Management.

Of course, some private equity deals have succeeded because of excess leverage, quick flips or onerous fees. However, several careful studies, including research published in the McKinsey Quarterly in 2005, have shown that the majority of companies acquired by private equity funds have outperformed thanks to substantially improved operations and better designed incentives.

A broad analysis of this outperformance reveals five key factors. While some may be unique to the privately held company, public directors should ask the following five questions, and consider the extent to which they can apply the answers to their particular company:

• Is there too much cash on the balance sheet? Firms acquired by private equity keep idle cash to a minimum. Yet there is a record amount of cash sitting on the books of public companies in the S&P 500 — $2.7 trillion in 2006 versus less than $900 billion in 1996. Is this cash hoard larger than needed as a safety cushion, or to finance merger “synergies” that may not materialize? While a share buyback can make sense in specific circumstances, raising a cash dividend is a much more reliable way to increase shareholder value. Citigroup research shows that stocks in the top quintile for dividend growth have on average outperformed those in the bottom quintile for dividend growth by 12.6% per year since 1990.
• Is the capital structure optimal? Private equity funds are well-known for increasing debt and reducing equity in companies they acquire. Historically, public companies have resisted adding leverage for fear it would damage their credit rating and lower their stock price. But the impact of a lower credit rating on a company’s market multiple (the price of a share of stock divided by its earnings per share) has shrunk sharply over the past five years. In 2001, companies rated A- or higher had market multiples of 22.6 and companies rated BBB had a market multiple of 17.0. As of 2006, the corresponding multiples were 17.4 and 17.3, respectively.
• Does the operating plan significantly increase shareholder value? In a 2005 study of 100 businesses owned by private equity in Europe, Ernst & Young calculated that the value of these businesses grew at twice the average annual rate achieved by public companies in the same country and the same sector. Why? According to the report, “Making long term improvements in the profit growth and value of businesses does not come from cost cutting or financial engineering. It comes from focused investment, making the few key changes happen fast, and the benefit of shared incentives of investors and management.” Some of these practices could be adopted to capture gains for public shareholders, with the right incentives for public company executives and directors.
• Is executive compensation tied closely enough to shareholder value? A relatively small group of senior executives at companies owned by private equity have much larger equity stakes than those in public companies. However, these senior executives will not actually receive any rewards unless the private equity fund owning the company actually realizes a substantial gain. Private equity funds also do not allow top executives to leave with large exit packages despite poor performance.
• Do directors devote enough time and have enough incentive to increase shareholder value? Private equity boards tend to be smaller, with a greater number of retired industry experts putting in more time on average than public boards. They deserve a much higher level of compensation — but not through annual fees. Directors of private equity companies hold substantial equity in them, and share in the performance fees of the private equity funds — typically, 20%-30% of the returns realized by these funds.

Such small boards may be particularly effective in smaller public companies, which have trouble recruiting outside directors. Large public companies could learn a lot by creating internal SWAT teams, who would play the hypothetical role of a private equity fund taking over the company. In either case, public directors would do well to pre-emptively apply some of the lessons of private equity now before the next deal cycle.

Mr. Pozen is chairman of MFS Investment Management. This op-ed is adapted from “What Public Companies Can Learn From Private Equity,” in the November 2007 Harvard Business Review.

In response, the National People’s Congress is about to consider a major overhaul of China’s social insurance laws: This presents a unique opportunity to put China’s social security system on sound financial footing. But the NPC will have to overcome two formidable barriers — the financial drag of legacy pensions from the pre-1997 economy and the local administration of a pension system for an increasingly national workforce.

In the communist era of the “iron rice bowl,” state-owned enterprises regularly promised pensions to workers, who made no pension contributions. In 1997, as China moved toward a market-oriented economy, it adopted a two-tiered payroll tax to finance social security (primarily in urban areas). Employers now should contribute 20% of wages to support a defined retirement benefit. Employees also are now required to contribute 8% of a worker’s wages to a personal account, with a variable retirement benefit based on investment returns.

The responsibility for paying social security benefits rests with local governments — provinces, cities or townships — which also collect the payroll taxes. Unfortunately, these local governments are using much of the employers’ 20% payroll taxes to pay pre-1997 legacy pensions to workers who never made any contributions.

Many local governments have even paid legacy benefits with some or all of the 8% in payroll taxes contributed by workers, which are supposed to be invested in personal accounts. Despite recent pilot programs by the national government in several provinces, a substantial portion of these personal accounts are not funded with actual investments — they are “notional” accounts with only paper credits. If these personal accounts remain “empty” until participating workers reach retirement, the result will be a new set of large, unfunded liabilities for local governments.

The solution is to pre-fund retirement benefits by holding the contributions in separate trusts and investing them. This would avoid the huge unfunded liabilities of pay-as-you-go social security systems, like those in the U.S. and Europe, where the number of active workers supporting each retiree is declining. China will face a particularly steep decline because the government is holding down population growth through its one-child-per-family policy.

Researchers Yaohui Zhao of Peking University and Jianguo Xu of Duke University have estimated that China could reduce the employer portion of its payroll tax to below 16% if it pre-funded the social security system. Such a reduction would broaden the participation of Chinese employers in the system. Right now, faced with a 20% payroll tax on top of other employment-based taxes — which together exceed 60% of payroll — only half of China’s urban employers make social security contributions. The system is virtually non-existent in rural China.

The present system, which uses current payroll taxes to pay legacy pension benefits, also undermines China’s heightened efforts to crack down on corruption. If local officials do not have to deposit all taxes in a separate trust, some will be tempted to divert the money for personal gain. Chinese prosecutors recently brought criminal actions against two senior officials in Shanghai for allegedly diverting pension funds to corrupt entrepreneurs.

To facilitate pre-funding, the NPC should shift the responsibility for paying legacy pensions to the national government. To finance legacy pensions, the national government could allocate a modest portion of its $1.3 trillion in reserves to the national social security fund. This fund already invests the proceeds from certain privatizations of state-owned enterprises to help local governments defray their pension obligations. In return, the NPC should insist that social security become a national system. Provincial officials are pushing hard to become the consolidators of social security for local governments because of the significant economic and demographic differences among regions. However, provincial officials in China are not well positioned to invest payroll taxes in diversified portfolios. More fundamentally, as workers move in response to changing employment demands in different regions, they need benefits that are easily portable and financially secure.

With social insurance legislation on the table, now is the time for the NPC to negotiate the grand bargain — relieving local governments of legacy pension obligations if they cede social security to the national government, and persuading the national government to invest all payroll taxes in trusts or other accounts dedicated to pre-funding the social security system.

Mr. Pozen is chairman of MFS Investment Management.