March 15 (Bloomberg) -- Tighter credit standards among mortgage lenders might lower U.S. home prices by 10 percent this year and push the economy into recession if the Federal Reserve doesn't respond by lowering interest rates, Merrill Lynch & Co. said in a report.

Merrill analyst David Rosenberg, who previously forecast the Fed would lower interest rates in the second half of 2007, said there are two possible scenarios. With a rate cut, economic growth will slow to about 1 percent. If rates are left unchanged, and housing prices fall 10 percent, the probability of a recession is ``very close to 100 percent,'' Rosenberg wrote.

``There could well be potentially significant further drags on home prices, construction activity and of course consumer spending,'' he said in a March 13 note to investors.

New Century Financial Corp., the second-biggest subprime lender in the U.S., and other mortgage companies are facing possible bankruptcy as the number of borrowers in the U.S. falling behind on payments has risen to a four-year high. More than 20 subprime lenders have closed or sought buyers since the start of 2006 and bank regulators are pushing lenders to raise credit standards.

Former Federal Reserve Chairman Alan Greenspan told the Futures Industry Association today that he expects the subprime mortgage problems to spread to the rest of the U.S. economy.

`Spillover'

``If prices go down, we will have problems -- problems in the sense of spillover to other areas,'' Greenspan said. While he hasn't seen such spreading yet, ``I expect to.''

Declines in home prices would have an effect on everything from furniture and appliance sales to landscaping and the price of copper. That would drive unemployment above 5 percent by the end of the year and make an ``outright recession'' more likely unless the Federal Reserve cut benchmark interest rates by a full percentage point, Rosenberg said.

``What we are concerned about most are the knock-on effects from the pullback,'' he wrote.

Profit at homebuilders has plunged in the last year as potential buyers first hesitated because interest rates rose, then because home prices were falling.

``I would've thought that it would've rebounded by now and I would've been dead wrong,'' Robert Toll, chief executive officer of the largest luxury U.S. homebuilder, said at a conference in Las Vegas.

Economic Recession

Analysts at Credit Suisse Group, Switzerland's second- biggest bank, said in a note to investors yesterday that stocks worldwide will weather a surge in U.S. subprime loan defaults.

``The key to whether or not fears of an economic recession and a far more severe correction in equity markets materialize rests on the shape of the labor market and the corporate sector,'' Credit Suisse said.

The Federal Reserve raised its benchmark rate to 5.25 percent in June, compared with an average target of 3.2 percent in 2005, a year when net new mortgage borrowing soared by a record $1 trillion.

Chairman Ben Bernanke has identified 1 percent to 2 percent as his preferred range for the inflation gauge most closely monitored by the central bank. The measure, which excludes food and energy costs, rose 2.3 percent in the 12 months to February.

Fed Forecast

Rosenberg, who wrote, ``It would come as no surprise to our readership that we are more concerned than most others on the outlook for the economy, housing and credit,'' predicted in May 2005 that the Fed would stop lifting interest rates at 3.25 percent and be forced to reduce them by the end of 2006. The Fed paused last August with rates at 5.25 percent. In October, Rosenberg forecast the Fed would cut rates by 50 basis points before the end of March.

Economists surveyed by Bloomberg News forecast the Fed will hold the rate through the third quarter, according to the median estimate. The board has not lowered the rate a half percentage point in a single stroke since November 2002.

Rosenberg estimated that subprime loans boosted home sales by at least 20 percent annually and the loss of that market might shave half a percentage point from the Gross Domestic Product.

In a March 1 report, CreditSights Inc. said rising mortgage defaults by subprime borrowers may add more than 533,000 homes to the market. That would increase inventory of new and existing homes by about 13 percent. The National Association of Realtors and the U.S. Commerce Department said 4.09 million homes were for sale in January.

Borrowing Increases

Mortgage borrowing rose by $792.5 billion last year, the smallest gain since 2002, according to the Fed's quarterly Flow of Funds report. The increase last quarter was the smallest since 1998, as two years of Fed interest-rate increases depressed loan demand and slowed the housing industry.

``The market is working,'' Doug Duncan, chief economist for the Mortgage Bankers Association, said yesterday as the Washington-based group released its quarterly report on delinquencies and foreclosures.

David Nissen, who as chief executive officer of GE Money oversees WMC Mortgage, the fifth-largest subprime lender in the U.S., said tightening credit solved the structural issues that caused the current mortgage crisis. WMC contributed less than $100 million of the parent company's $20.8 billion in net income last year.

`Short-Term Shock'

``This is a short-term shock,'' Nissen said. ``By the end of 2007 this will have played out.''

Burbank, California-based WMC Mortgage, General Electric Co.'s U.S. mortgage unit, fired 20 percent of its staff last week and stopped making loans to borrowers with low credit scores.

``Borrowers will feel the pinch over the next couple of years,'' Nissen said. ``There's lots of liquidity in the market and as long as jobs hang in there and there's low unemployment, the economy will be good in the United States, not great.''

To contact the reporter on this story: Sharon L. Crenson in New York at screnson@bloomberg.net

Last Updated: March 15, 2007 16:53 EDT