For eight months now I have been launching a new hedge fund specialising in distressed residential mortgages. It has been a fascinating experience where I find myself using every ounce of my 35 years of Wall Street experience and training. Our basic premise is to buy defaulted mortgages from the US Government (specifically buying them from holders of these insured mortgages and agreeing with the FHA to strip off the insurance), modify the mortgage to significantly reduce principal and monthly payments as well as forgive all arrears, and then work the mortgages to either re-perform or take them down an alternative recapture path that hopefully avoids the foreclosure track wherever possible.

When one considers the global economic spiral we find ourselves in (whether considering the US housing crisis or the European sovereign debt crisis), it is clear that we are going through a phase in the cycle where we are forced to grapple with the overindulgences of the past. In the US, we allowed homeowners to over-leverage and presumed that housing prices would grow to the sky. In Europe we allowed the weaker EC countries to over-leverage and spend profligately to create lifestyles that mimic those of the wealthiest nations and then presumed that any shortfall would get propped up by the pillars of the EC (Germany and France). To integrate these two problems, try watching House Hunters International some evening on HGTV, one of the new breed of lifestyle cable channels. What you see are homes and condos built on lovely and otherwise desolate beaches in every corner of the Mediterranean. These condos enjoy the latest in technology and design style and are ultra-luxurious by any standard…..and are now going begging for buyers for several hundred thousand Euros. If it was possible to put a Euro or, better yet, Drachma denominated mortgage on the property, the cycle would be complete.

The point here is the explosion of mass media and the internet has given everyone a picture of the good life to mimic. We are all prone to thinking that life only gets better and better and thus more and more demand will exist for these luxurious accommodations which we are building with borrowed money and government subsidies. So let’s finance the dream and flip it for an easy money gain and move on to the next dream. What we have ignored is that income disparities have not only NOT broadened the middle class and created more affluent buyers of this dream, the Great Recession has exacerbated income disparity and made it harder for the population to afford this growing list of “necessary” luxuries. Someone has to actually be productive enough to be able to afford the dream. This may be a fulfilling cycle in places like China, but it is certainly not in Japan, the US or Europe.

The developed economies might be more accurately described as the aging and enfeebled economies, where the impending burden of underfunded retirement obligations are more pressing concerns than broadening the income base. Europe is at the forefront of this mess with its pillar economies having the worst funded retirement systems in the world. Supporting Greek granite counter tops definitely takes a back seat to paying German pensioner benefits when push comes to shove. Japan, on the other hand, led the way in overinflating and overleveraging real estate (mostly commercial)….and then allowing two decades to go by without recognising the imbedded loss….and thereby inventing the Great Stagnation. The US has now had its come-to-Jesus moment in the US residential housing market. Wall Street has taken its bullet in the form of structured products which have blown up in its face. Regional banks have taken it in the neck with BOTH commercial and residential mortgage defaults. And now the US Government is faced with mortgage guarantees that are cutting a wide swath through any and all budget squeezing efforts.

Where does this leave us? Well, in Europe, I predict that the deferred pension obligations of Germany and France will ultimately force the EU to leave the Mediterranean countries to finance their own lifestyle choices….whether by letting Greece and others leave the EU or simply disbanding at least the common currency if not the EU. Take the pain and move on.

In the US, I believe our object lesson is Japan and how we avoid two decades of misery. It seems that recognising, absorbing and moving on from the asset depreciation is critical. Take the pain and move on.

This is the investment thesis at my new hedge fund. Buy the mortgages out from the government insurance (at a reduced net cost to the government due to truncating the deterioration of the foreclosure cycle). We then reduce principal to give the homeowner 5% positive equity and motivate them to re-perform. If it works, the homeowner gets relief and we all move on without the community disruption and property deterioration of foreclosure. The government takes its pain and moves on. We as lender take our pain (opportunity loss) and move on. The homeowner gives up his foreclosure free rent program and gets back on a responsible and sustainable path. Everyone wins one way or the other. For those worried about moral hazard, justice may not be completely served, but this problem we face is more like a natural disaster than a debtor peccadillo. We all need to focus on solutions like this that take the systemic stress out of the market distress that we all face.