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.

Below are some details on the Fed’s proposed new mortgage rules courtesy of Briefing.com:

• New final mortgage rules ban prepayment penalties if payment can rise in first 4 years.
• New rules create category of ‘higher-priced mortgages’ including virtually all subprime loans.
• Lenders must verify repayment ability from income, non-home assets for higher-priced mortgages.
• Lenders must assess repayment ability on highest scheduled payment in first 7 years of mortgage.
• Lenders must establish property tax, insurance escrow on higher-priced first-lien mortgages.
• Lenders may offer borrowers opportunity to cancel escrow account after one year.
• Creditors must provide estimate of mortgage costs, payment schedule,within 3 days of application

If mortgage regulators can enforce their new rules on “higher-priced mortgages,” at least as well as they do for “high-cost mortgages,” (which they actually do surprisingly well) this new category of home loan means one thing: don’t bother applying for a mortgage unless you have nearly spotless credit and money in the bank.

And while many would argue this is a much needed change in the mortgage market, it does raise a few questions:

• Won’t this further increase demand for rental units?
• Won’t this force people to save if they want to own a home?
• Isn’t money saved different than money spent?
• Where was this legislation in 2006, at the height of the boom, even when regulators knew what was going on?
• Why do regulators seem to focus so much on making new rules, rather than enforcing the old ones?
• If the mortgage market figured out how to get around the old, “high cost loan” limitations, won’t it eventually work its way around these as well?

While Congress deliberates on the future of the nation’s mortgage market, some within the government are calling for restraint in regulatory reform. Housingwire.com reports William Emmons, an economist at the St. Louis Fed, is calling for patience and social support as the clearest way to economic recovery.

Emmons makes the argument that government intervention, particularly measures aimed at postponing or eliminating the foreclosure process, will only serve to further tighten the credit crunch that already holds the nation’s economy in its teeth. Instead, he believes Federal funds and regulations should be aimed at helping foreclosed homeowners recover from their unsuccessful forays into homeownership. By focusing on the “cause,” rather than the “symptoms” of our current economic woes, and by allowing markets to sort themselves out, Emmons argues prudent, forward-looking regulatory reforms offer us the fastest route to economic health.

Whatever your opinion on upcoming regulatory reforms, it is clear the actions of the government in the coming months will have a massive impact on housing markets and the economy as a whole. Reforms that promote a healthy and functioning mortgage market while protecting borrowers from the types of abuses so prevalent during the boom will allow investors and homeowners alike to make the right choices in the coming years.

The real estate and mortgage industries are busy battening down the hatches for the inevitable tidal wave of regulatory reform. Meanwhile, Housingwire.com reports government officials are already hard at work trying to outdo each other as the protector of the “everyday common household victim” of our “national crisis.”

Two illustrative examples of regulatory restructuring have been rolled out in last two months. In New York State, legislators passed a series of measures essentially placing a one-year moratorium on foreclosures. Under the program, borrowers already in default will pay a nominal monthly sum and be eligible for state funds to supplement existing mortgage obligations.

In California, lawmakers passed legislation that would require more extensive notification for delinquent borrowers before the foreclosure process can begin. Homeowners would be entitled to meetings with servicers to learn their restructuring options, placing a greater onus of responsibility on servicers to reach out to borrowers prior to beginning foreclosure proceedings.

Both measures are designed to ease pressures on distressed borrowers, but the New York plans go well beyond those in California. The California laws are designed to ensure increased communication between borrower and lender. The New York law is designed to put a halt to the process of foreclosure, presumably to await more extensive reforms or bailout plans still to come.

In both states, these measures mark the tip of the iceberg in the process of reforming regulatory frameworks for mortgage lending. In this election year, public support is swelling for pieces of legislation like these and even larger moves are likely on their way.

The challenge for regulators — and the lobbyists so generously pleading their case — is to enact rules and enforcement schemes that prevent fraud and predatory lending, without being too constrictive to legitimate business. Many such rules already exist; it remains to be seen if the fallout from the collapse of the mortgage industry can convince regulators to enforce their own rules.