Housing mess risks recession unless Fed cuts: Merrill

NEW YORK (Reuters) - House prices could tumble 10 percent this year and raise the chances the United States may slip into recession unless the Federal Reserve cuts interest rates to cushion the fall in economic growth, Merrill Lynch said in research notes this week.

If correct, the prospects of this scenario will prove troubling for equities investors, who could face a stock market decline of 30 percent or more as measured by the S&P 500 index .SPX , the brokerage said.

Merrill said the biggest concern is that tighter lending standards in the mortgage market, even if confined to lower-quality borrowers, will constrain overall housing demand and hamper recovery in the struggling housing market.

"It is not inconceivable (given what is happening now to mortgage originations) that we end up with something closer to a 10 percent decline in home prices this year," Merrill Lynch said.

Merrill said this alone would slow the economic expansion to a rate of about 1.5 percent to 1.75 percent this year, which it termed a "growth recession."

The traditional definition of a recession is two consecutive quarters of declining gross domestic product.

However, if the inflation-fighting Federal Reserve were to keep rates unchanged to contain price growth -- instead of cutting by 1 percentage point in the second half of 2007 as Merrill expects -- then this would put the probability of an outright recession in the second half at "very close to 100 percent."

In the past, moves by financial markets to price in some risk of a recession, without a recession actually occurring, have led to an average drop in the S&P 500 of 16 percent in sell-offs lasting 13 weeks.

"But if we do end up seeing a recession, then it's game over: the historical record shows that the average decline in the S&P 500 is 34 percent and the average duration is 37 weeks - more than double the magnitude and triple the duration of classic non-recessionary correction," Merrill added.

The Merrill notes reflect the debate in financial markets in recent days, which has centered on whether the crisis in the subprime mortgage market can be contained.

Former Federal Reserve Chairman Alan Greenspan said on Thursday there was a risk that rising defaults in subprime mortgage markets could spill over into other economic sectors.

Greenspan said that subprime woes were "not a small issue" and seemed to result primarily from buyers coming into lofty housing markets late after big price run-ups that had left them vulnerable to hikes in adjustable mortgage rates.