As lenders prepare for the worst, will prices tumble down like a house of cards?

Julian Knight reports on the possibility of a vicious circle in which falling values choke off the supply of mortgages, translating in turn into further falls

British mortgage lenders are planning for a slump in UK house prices of up to 20 per cent over the next couple of years.

Lenders are required by City regulator the Financial Services Authority (FSA) to "stress test" their mortgage lending. In other words, they have to check that they would still be solvent and able to operate if the wider UK economy was gripped by major problems such as rising unemployment or even a doubling of interest rates.

One of the key scenarios in the test is a fall in property prices.

This is important because a housing market crash would reduce lenders' assets substantially, affecting their balance sheets and their ability to obtain funding on international money markets.

In recent weeks, a growing number of lenders have been making their house price scenarios even worse, heightening general fears that a property crash may be imminent.

"We are not predicting that house prices will crash. But whereas in the past we were modelling for a 5 or 10 per cent property price fall, we are now testing against a 15 or 20 per cent fall," explains Matthew Bullock, chief executive at Norwich and Peterborough building society.

"It's all part of responsible lending and we know that we can stomach it and much worse," he adds.

Bradford & Bingley, a major player in the buy-to- let market, has undertaken a similar review of its stress tests. "We have three scenarios – a small fall, a mid- level fall and a doomsday scenario," says Andy Wiggans, B&B's director of mortgages. "The doomsday scenario has stayed the same but, like other lenders, what we see as a mid- ranking fall has worsened a bit in reaction to the problems in the housing market."

However, Mr Wiggans says B&B's business model means it is well placed to ride out any market slump. "Buy to let is counter cyclical to a certain degree. If general house prices crash then more people look to rent, and this helps landlords meet their own mortgage repayments. In addition, buy-to-let mortgages tend to require a bigger deposit and this in turn provides a cushion against negative equity," he adds.

Lenders, it seems, are getting increasingly spooked about the possibility of a crash. And reading the market runes, it's easy to see why. Estate agents say buyer enquiries are plummeting as people's finances are squeezed by a combination of higher utility bills and rising food prices. The latest figures from the Land Registry show property values going into reverse in many parts of the country.

But this may be just a taste of things to come. The big issue playing on the minds of lenders is the worsening credit crunch and the knock-on effect on the mortgage market – in other words, the raising of rates and the withdrawal of riskier products. Ultimately, this may feed through to the wider market, prompting further price declines.

"The crunch is the major concern for all those connected with housing," says Ray Boulger from mortgage broker Charcol.

"I am not saying that there will be dramatic falls, but inevitably if the supply of mortgages is choked off, this will have a depressing effect on prices.

"What we are seeing already is that many of the mortgages that only require a small deposit are disappearing," he adds. "And if first-time buyers can't get on the ladder then this removes vital fresh blood from the market and means that further up the chain fewer people can move."

The "choking" of mortgage supply is starkly illustrated by figures from financial comparison site Moneyfacts. These show that the number of variable- and fixed-rate mortgages on offer has fallen from nearly 16,000 last summer to around 5,000 today.

Last week, First Direct became the first big lender to shut it doors to mortgage applications from people who don't already have another financial product, such as a savings or current account, with the bank.

First Direct said it had taken this step because it had recently been inundated with new mortgage applications and was finding it hard to cope with the administration. As a result, the bank added, it had decided to halt supply temporarily rather than try to discourage demand by raising its rates dramatically.

If house prices slide, other banks might follow First Direct's lead, with the result that prospective homebuyers find it harder and more expensive to fund their property purchase. This could all have the effect of creating a downward spiral in prices, regardless, to a degree, of what happens to Bank of England interest rates or employment.

And Mr Boulger reckons that substantial falls may already be underway.

"The indications I am getting are that house prices are already 10 per cent below what they were at the height of the market last year," he says.

Mr Boulger's view of a housing market going backwards was borne out last week by the latest mortgage lending figures from the Bank of England. It said that the number of new loans made for house purchases in February – a key indicator of market activity – had fallen sharply. Just 73,000 mortgages were approved during the month. This represents a 39 per cent year-on-year fall and means that mortgage advances have sunk to levels last seen during the market crash of the early 1990s.

No wonder, therefore, that the Nationwide building society, which has been relatively bullish, recently backpedalled from its forecast that house prices would be stable in 2008, predicting instead a small but not insignificant fall.

Bank group Lehman Brothers went further last month and said that it expected house prices to have fallen 8 per cent by the end of next year.

Meanwhile, Abbey, which is among the fast-dwindling band of lenders still to be offering mortgages aimed at first-time buyers – only requiring a 5 per cent deposit – says it is on the alert for a downturn. "Although our outlook for house prices in 2008 remains broadly flat," says a spokesman for the bank, "the chances of falls in 2009 or 2010 have been increasing."