There are precedents from previous crises in the 1990s, Gross said. The U.S. government created the Resolution Trust Corp. to rescue the insolvent savings and loan industry, and the Fed organized a bailout to prevent billions in losses from rippling through Wall Street after the collapse of Long-Term Capital Management LP hedge fund in 1998.

"Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2 million homeowners to the wolves in 2007?" Gross wrote. "If we can bail out Chrysler, why can't we support the American homeowners?"

Gross advised President George W. Bush to set up a "Reconstruction Mortgage Corporation" and "write some checks" to bail out homeowners.

"Even cuts of 200-300 basis points by the Fed would not avert a built-in upward adjustment of adjustable-rate-mortgage interest rates," Gross said. "Nor would it guarantee that the private mortgage market, flush with fears of depreciating collateral, would follow the Fed down in terms of 15-30 year mortgage yields and relaxed lending standards."

If U.S. home prices fall by 10 percent, it would be the worst asset deflation in the United States since the Great Depression, according to Gross.

"Now many of those that bought homes in 2005-2007 stand a good chance of resembling passengers on the Poseidon — upside down with negative equity," he said. Seventy percent of American households own homes.

As no one really knows where the defaulting mortgages will arise and how many rest in institutional portfolios, the investments can hibernate for many months before investors get to find its true value, Gross said.