Celebrated investor Wilbur Ross noticed last year that a hedge fund had committed $20 million to a loan syndicate for one of his portfolio companies but had failed to attend any of the due diligence sessions. He called up the senior partner of the large fund to thank him for his participation, and to let him know that his shop had missed the investor briefings. “Since it’s only $20 million, we didn’t think it was worth sending someone,” Mr. Ross says he was told.

Times have changed.

“That was the giddiness, the total abrogation of risk management that prevailed”, Mr. Ross says. “That’s gone. Many of the hedge funds that had that attitude are gone, too.”

He adds: “That was one extreme. Now, even on safe things, people are inventing reasons not to lend. … There’s probably the same amount of money floating around the world as there was a year ago, but, whereas a year ago we were drowning in liquidity, now people are dying for lack of liquidity, and all that’s changed is the psychology.”

The uncertainty about mortgage defaults is a major constraint, and one that Mr. Ross says he thinks he can help solve.

He proposes a private-public partnership aimed at reducing the amounts of outstanding mortgages (so that the mortgages approach actual property values) and restoring liquidity to lenders. His plan suggests that the Federal Housing Administration provide a guarantee for the amount by which a lender reduces a loan total, and in return the FHA would earn an insurance premium and would share with the lender in any gain realized on the property when ultimately sold.

Under his plan, lenders could sell the guaranteed portion of the loans, thereby accessing liquidity. The benefits of the program would apply to qualified home buyers, but not to subsequent owners. Although the details of his plan are still tentative, Mr. Ross says he hopes the government will give it some attention.

Meanwhile, in the midst of this panic-prone world, Mr. Ross is bottom-fishing. Last year, he set out to raise a $2.5 billion fund and ended up with $4 billion. Until 75% of that fund is committed, he is not permitted to go back to the well. That might not take much longer. “We’ve been busy,” he says, and indeed he has.

Mr. Ross is one of the few investors who has been tiptoeing into the water after the waves of mortgage defaults. Beginning last year, he has made some selective investments in the area, including buying into American Home Mortgage Investment as it entered bankruptcy and later arranging to purchase its mortgage servicing arm. He has agreed to buy for more than $1 billion the servicing business of Option One Mortgage, a unit of H&R Block. He also stepped up earlier this month to buy a stake in Assured Guaranty, the fifth-largest bond insurer.

These selective moves set him apart from most investors, who are sitting on their over-leveraged hands. How does he know that we’ve hit bottom? “We don’t care if it’s the bottom,” he says. “We know we can make a high rate of return without using a lot of leverage. We never have used a lot of leverage; never got involved in PIK loans or toggles, for instance,” he says, describing some of the more esoteric and ultimately unstable financial instruments much in vogue 18 months ago.

That’s not to say that Mr. Ross is especially bullish. “There’s been this tremendous psychological shift. It will be quite a while before it goes back. There are whole categories of activity which have been wiped out. For instance, the faith in black boxes, it’s gone, and rightly so,” he says.

Mr. Ross is scornful of the computer-driven trading schemes that have grown exponentially in recent years. “They look so official, with their big computer runs and pages of assumptions, stress tests, and all that,” he says. “But the fundamental assumption underlying any black box is that tomorrow will look a lot like today, or yesterday. Flash forward to subprime mortgages. Where the models got into trouble was in not anticipating the change in lending standards. There was a lot of fraud in the mortgage business, FICO scores were faked and so on. The models couldn’t see that, but if anyone investing in these instruments had spent time with the mortgage brokers, they would have seen what was happening.” He added: “The Street is so frightened. No depositary institution can survive a run. The problem for Bear Stearns was not a balance sheet problem, but a confidence problem.”

Mr. Ross says he thinks the Fed was completely correct to have stepped in to keep Bear Stearns from going under.

“I was in Japan that weekend. People over there were petrified. If Bear had gone under, the Asian markets were going to crash. Other firms would have failed as well,” he says.

What should the Fed be doing now?

“Whatever they do, we’ll probably have more failures. They can fine-tune at the edge, but they’re not going to cause a quick bounce back,” Mr. Ross, who expects that recovery in the financial markets is going to extend beyond this year, says. He says he thinks it was useful to have the Fed make the discount window available to investment banks, but he is concerned that other kinds of financial services companies may cry foul.

He does not share the view of some investors that the SEC should step in to revoke the accounting rule requiring financial institutions to “mark to market” their portfolios.

“Marking to market is a good thing” Mr. Ross says. “The old system hid too many problems. Accounting didn’t create these problems; leverage of 33 to one did.”

Mr. Ross sees America as being in a “real world consumer- and credit-led recession,” even if it has so far avoided the technical definition of one.

Time will tell whether recent careful moves by Mr. Ross are foolhardy or financially prescient, but his history suggests the latter. On the other hand, he paints an uneasy picture.

“We’re in a rough patch,” he says. “There will always be booms and busts, and there is no silver bullet.” Rats.

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