Housing and housing finance present the largest risk to the overall economy, according to Morgan Stanley analysts, who said they were too optimistic last year when they predicted “only a modest recovery in housing” for 2010. Analysts said there are many options available to fix the nation’s “dysfunctional housing and mortgage markets, but the political will to deploy them is scarce.” The analysts suggest additional loan modifications or refinancings, or principal writedowns may help ease the problems facing the industry. Banks have tightened lending standards and there’s a shadow inventory of some 8 million units that create a vicious circle, according to Morgan Stanley. And without substantial policy reform, the imbalance won’t correct itself for years and home prices may fall another 10% before reaching bottom in 2012, the analysts said. Morgan Stanley also said the risk of mortgage putbacks is restricting the supply of credit, as banks are only lending to borrowers with pristine credit and proper housing equity. Still, the analysts expect loan originators to see losses of $85 billion to $165 billion from the putbacks with large-cap banks bearing the burnt of the losses. Analysts said policymakers should first focus on repairing housing by reducing the supply and demand imbalances and restore market functioning. Then reforms can be implemented “to assure longer-term financial and economic stability.” Write to Jason Philyaw.

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