There are many problems:

- Namecoin fixes the cost of registration according to a formula for a long period of time. Price fixing is always a bad idea.
- When the price fixing ends, generators will be able to generate all of the good domain names at almost no cost. (This is better than the ICANN DNS, but it should be avoided if it can be.)
- Generators will intercept registration transactions and register the domains themselves, holding them hostage to get more money.
- Even ignoring the above two problems, domain registration will probably be too cheap. Miners don't care about how cheaply domain squatters can register domains.
- To resolve domain names by yourself, you need to download all new blocks. Blocks will grow in size, and eventually the network will become semi-centralized (as Bitcoin will). This can be avoided for resolvers if you're building a separate system, and it's one of the only reasons I see for not building onto the Bitcoin block chain.

DNS needs a lot more thought.