Housing price declines remain the greatest challenge to financial markets and could prompt a deep recession, according to Pimco's Bill Gross.

Gross, who manages the world's largest bond fund at Pimco, said U.S. home prices are set to decline another 10% in the coming year and suggested that the U.S. government intervene to prop-up the crumbling market.

"A continued housing deflation of several trillion more dollars now threatens to impact the real economy which in turn might produce a reversal of financial market fortunes," Gross wrote in his monthly Investment Outlook published on Pimco's website. "This recession, although currently mild and as of yet not even officially validated, may not be your garden-variety, father's Oldsmobile-type of downturn."

On Tuesday, the S&P/Case-Shiller Home Price Index for the largest 20 U.S. metropolitan cities declined 12.7% year-over-year.

Gross said government-subsidized loans at below market rates would aid the housing market. Cutting the Fed funds rate further will only further devalue the U.S. dollar and spur inflation, he said.

"Home prices which have fallen by 10% over the past 12 months and are set for a repeat by this time in 2009. Lower Fed Funds? They would, in Pimco's opinion, likely do more damage than good from this point forward," Gross wrote.

Gross said Pimco avoided the subprime meltdown, in part because their decisions were guided by Hyman Minsky's Stabilizing an Unstable Economy.

"Because the U.S. and selected other economies are now substantially asset-based and dependent on stable and upward tilting prices, a deflation of an economy's primary financial asset can be ruinous. Its deflationary thrust must be countered, wrote Minksy, or else the battle might be lost," wrote Gross.

In recent weeks, equity markets have trended higher and U.S. Treasuries have been selling off as the de-leveraging process winds down and the credit markets stabilize. Gross said Co-Chief Investment Officer Mohamed El-Erian has been counseling Pimco clients to prepare for another flight-to-quality.

"Mohamed suggests the possibility, not the probability, that recent euphoric moves in equity prices and credit market spreads might be premature," Gross wrote.

By Adam Button and edited by Stephen Huebl