By ANDREW JEFFERY

This post first appeared on Minyanville.

In its ongoing attempt to rewrite the rules of what’s quickly becoming our quasi-capitalist nation, the Obama Administration is weighing options that would expand compensation restrictions to all corners of the financial-services industry.

According to the New York Times, well-publicized efforts to rein in executive pay at firms that accepted TARP money could extend to companies that have thus far stayed off the government dole. In other words, the spottily regulated world of hedge funds and private equity could be subject to some of the same restrictions faced by their government-subsidized competitors.

However unpleasant, firms like Citigroup (C) and Bank of America (BAC) (both in hock to the US taxpayer for hundreds of billions of dollars) have lost their right to be the masters of their own executive compensation destiny. On the other hand, pay at hedge funds that haven’t touched a penny of government money should be determined by the firms themselves.

Since he took office, President Obama has been a loud advocate for pay that’s closely tied to performance. The prevailing view in Washington is that Wall Street traders were able to take on massive risk — either their firm’s or their clients’ — without feeling much pain if the bets went sideways. This led to excessive risk-taking, and the kind of near-criminal alchemy that ultimately blew up the financial lab.

And while this is true to an extent, the result of this typical government overreaction will be a system reduction of risk - and by extension, of reward. Financiers, entrepreneurs and businesspeople of all types engage in risky behavior every day - which is what keeps the economy humming.

Systematically reduce the incentive to take risks, and economic output will slow. It’s simple math.

Already, even as Washington bumbles its way towards legislation on executive pay, what’s left of the free market is sorting things out on its own.

Raising capital is well-nigh impossible for upstart hedge funds, as even management teams with strong credentials are struggling to get off the ground. Existing funds, most of which remain below their so-called “high-water mark” (the level at which juicy performance incentive fees kick in), won’t see big bonus payouts until well into 2010.

This is the market at work, punishing bad actors — even ones that were just marginally bad — and creating an environment where only the most astute, talented, and driven can succeed.

By contrast, as policymakers look to make up for years of ignoring their fiduciary responsibility to safeguard the public interest, we’re witnessing the development of an economic system that benefits only the most well-connected.

Needless to say, this is an unwelcome progression.

This post first appeared on Minyanville.

Yesterday, I criticized Washington’s $700 billion financial bailout plan for missing the point. It fails to address the root of the problems facing the housing market and, by extension, the rest of the economy: Negative equity or a homeowner owing more on his house than it’s worth.

On The Exchange, several sharp-minded Minyans pressed for details on how the government could execute a program to “absorb negative equity” in a fair, equitable, efficient manner - and without bankrupting the entire country.

To be clear, I’m fundamentally opposed to government intervention into the free market beyond a requisite regulatory capacity. I’m also deeply skeptical that government can manage any program, large or small, with even the slightest degree of aptitude.

Unfortunately, the usefulness of ideological debate is growing fainter by the day. Practical solutions must be put forth and implemented immediately, lest we slip further toward a second Great Depression. Historians are welcome to argue semantics while we get down to fixing the problem. Only a mixture of public and private enterprise can repair the damage.

Negative equity creates a number of serious problems for the housing market, such as:

Foreclosures

Negative equity turns defaults into foreclosures. Delinquent borrowers can sell their way out of the problem if they can find a buyer at a level higher than their outstanding mortgage (plus closing costs and real estate agent commissions). But being underwater makes this impossible without coming up with the difference between the loan amount and the sale price.This is cash most struggling homeowners simply don’t have.

Oversupply

Negative equity exacerbates existing oversupply issues, pushing home prices down further. Sellers who haven’t yet missed a payment must list their house at least as high as their outstanding mortgage. But if a homeowner is upsidedown, the property gets listed too high and stays there. Borrowers must then choose to continue pouring money into a losing bet, while hoping someone buys their house at well above its market value. The alternative is to default and end up in foreclosure.

Bank losses

Once a mortgage becomes delinquent, banks must write down the asset and take a loss. Not only is the loan impaired because of the delinquency, but negative equity enhances the bank’s losses. As property values fall, balance sheets become even more impaired, mortgage-backed securities continue to lose value and the entire financial system becomes even more desperate for capital.

Banks are bleeding cash: JP Morgan (JPM), Wells Fargo (WFC), Citigroup (C) and Bank of America (BAC) all recently announced reduced earnings and were forced to take equity injections from the Treasury. Lenders are reticent to accept short sales (allowing borrowers to accept a sale price lower than the loan amount without making up the difference) because they can’t handle the losses.

Now, for the solution(s).

There’s no magic bullet, no one solution that can, in one fell swoop, wipe the slate clean. As I’ve described it, “sopping up negative equity” is an immensely complicated task. The mortgage industry is massive, inefficient, disjointed, riddled with redundancy, buried in paperwork and plagued by bad regulation and misplaced incentives. In short, it’s a mess. Cleaning it up will take a very, very long time.

Still, I’d argue spending money on the programs below — without any hope of it being returned — is a better use of taxpayer funds than watching hundreds of billions of dollars simply disappear into the opaque balance sheets of what remains of the financial system.

There may be additional solutions, but this laser focus on earning taxpayers a return on their investment dilutes the effectiveness of many important initiatives.

Principal Forgiveness

Fannie Mae (FNM) and Freddie Mac (FRE) are already experimenting with a pilot program to give borrowers the amount of their negative equity as an unsecured loan. Based on the most recent appraisal (appraisals are, for all their faults, currently the most accurate way to value individual homes), Fannie and Freddie could pay down the negative equity — plus some cushion for future depreciation — and refinance the existing loan at, say, an 80% loan to value.

Even if the government-sponsored enterprises started with just their own portfolio, that would be a huge step in the right direction. For loans owned by banks and in securities, Fannie and Freddie could pay off the mortgage at the outstanding balance, forgive the necessary principal and write a new loan.

At this point, the homeowner is free to sell the house at the new, lower market price (price discovery) or go on making the now much-more-manageable mortgage payments.

Shared Equity

Banks could “sell” negative equity to Treasury, sharing any future upside based on each party’s pro rata share of the home’s current value (again, we’re forced to use appraisals because there just is not a better option - yet). When the home sells, the bank and Treasury would participate in any future appreciation. If the home’s value continues to slide, the bank is less exposed to the losses.

Bank’s could effectively choose the amount they write off: The more they receive from Treasury, the less upside exposure they retain. On the flip side, stronger banks would be able to write off just enough to stay afloat without losing future earnings potential.

The U.K. is already trying a version of this program.

Homeowners, out from underneath the negative equity and armed with lower mortgage payments could stay in their homes or sell at the current market price. Again, forced price discovery while keeping people in their homes.

Community Redevelopment

I believe the best way out of this mess is to set up a federal land bank system, where funds are distributed by the Treasury to local community development organizations and vetted real estate developers. I recognize the potential for bureaucratic abuses, but unfortunately the government is the only organization with the scope to handle the problem on a national scale.

Just as we now have a Bailout Czar, we need a Housing Bailout Czar to oversee such a program. I’m sure Goldman Sachs (GS) could send up another of its finest for the betterment of the country.

Groups like Habitat For Humanity, which have existing ties in the community and teams of professional and volunteer contractors, could dramatically help rebuild struggling communities with requisite resources from the federal government. These groups could either buy foreclosed properties, refurbish them and rent them out, write low cost mortgages through the land bank or offer up funds to enable banks to accept short sales.

If there’s a better use for taxpayer money than rebuilding communities after a tragedy, helping families put their lives back together - I’m not sure what it is.

Will some speculators be helped in the process? Probably. But the good news is the widespread economic implications of this crisis, which are now inevitable, will take care of much of the moral hazard we so fervently argue against.

Not every stock speculator was taught his lesson after the stock market crash of 1929, but the Great Depression did affect an entire generation, encouraging thrift and aversion to risk for decades. Now isn’t the time to take the moral high ground, only to watch our cities washed away by the rising flood of poverty.

This isn’t socialism, it’s being American.

This post first appeared on Minyanville.

Some say the definition of insanity is trying the same thing over and over again, expecting a different result. By that measure, voters should load up on straitjackets this November and drag everyone in Washington off to the nuthouse.

Despite overwhelming evidence that we’re in the middle of a debt crisis, regulators insist they’re wrestling a liquidity crunch. And all the while, a cancer continues to eat away at the guts of the economy: The housing market. Only when it stabilizes will the financial system and, by extension, the economy - recover.

And yet, despite this widely recognized fact, the recent $700 bailout package contains little support for struggling homeowners. Even the $250 billion being dumped into banks will have only a minor effect on property values.

Smothered under the weight of falling home prices and tight credit conditions, consumers are reining in spending, as evidenced by yesterday’s bleak retail sales data. The economy is following the housing market into the abyss.

Since last summer, Washington’s tactic has been to encourage loan modifications through HOPE NOW and Project Lifeline and to widen the scope of government-backed loan programs via the Federal Housing Administration, Fannie Mae (FNM) and Freddie Mac (FRE).

As noted in the Wall Street Journal and discussed ad nauseum here at Cirios, these measures are woefully inadequate to stem the continued decline in housing prices.

As property values fall, over-leveraged borrowers find themselves underwater, or owing more on a house than it’s worth. In order to sell, the homeowner must come up with the difference between the sales price and the balance of their mortgage. For most, this is cash that simply doesn’t exist.

As a result, homes sit on the market for months, further pressuring home values. Despite the insistence by some real-estate agents that this is a buyer’s market, it most certainly is not. Until bloated inventories fall, home prices will continue to slide, making buying a home a dangerous proposition in the vast majority of the country.

Meanwhile, politicians continue to bang their heads against the proverbial wall, backing programs simply that do not work with the scope and efficiency that’s needed. Loan modifications, opening up mortgage guidelines and providing tax breaks so homebuilders like Centex (CTX), Pulte Homes (PHM) and KB Homes (KBH) can sell more overpriced houses may help a select few, but they do little to address the root of the problem.

Until taxpayer funds are appropriated to absorb negative equity, price discovery in the housing market will be a long, agonizing process.