Nationwide’s worse-than-expected 2.5 per cent drop in house prices this month has raised fears that the housing market is seeing more than a minor correction.

A readjustment of prices had always been on the cards after the average cost of a home jumped 171 per cent over the previous ten years and led to affordability becoming stretched as house prices increased faster than earnings.

But yesterday’s figures were far worse than the 0.5 per cent fall forecast by most economists, suggesting that the correction may become deeper and more prolonged.

The problems have been made worse by a number of factors, led by a series of interest rate rises in 2006 and 2007, which further increased affordability constraints. This was then followed by last summer’s credit crunch and its dramatic effects on the mortgage market.

The crisis in wholesale money markets has made it more difficult and more expensive for lenders to borrow money and this has caused firms to raise their rates and withdraw certain products.

As a result, there are now around 75 per cent fewer different mortgage deals available than there were last July. This has led to more people chasing fewer loans and lenders with competitive deals are receiving more applications than they can process. To stifle demand, they are increasing their rates and tightening their lending criteria.

As soon as one lender raises its rates, other lenders look more competitive and are inundated with business, meaning they also hike their rates to try to curb demand.

There had been hopes that conditions in credit markets were easing thanks to central bank intervention and that this would start to filter down to the home loan sector.

Abbey and Woolwich indicated these hopes may have been overdone as they lifted borrowing costs, making it harder again for borrowers to secure mortgages.

It has now become almost impossible for a first-time buyer without a deposit to get a mortgage, with only a handful of products available that will lend 100 per cent of property value.

The number of 95 per cent mortgages has also halved during the past 12 months and people face paying much higher rates if they do not have a big deposit.

Meanwhile, lenders have become more conservative about the salary multiples they are prepared to advance, making the situation very difficult for first-time buyers.

Mortgage data earlier this week from the British Bankers’ Association showed a small increase in the number of loans for house purchases in April – up 3,158 to 38,704 – although the figure is still at historically low levels and failed to ease concerns that there may be a sharp slowdown on the horizon.

Until now, economists have said that the current constraints on the market will lead to falls in the number of homes changing hands and slight annual price decreases, but not the steep house price falls seen in the early 1990s crash.

The house price crash seen then was triggered by large numbers of people being forced to put their homes up for sale due to a doubling in interest rates and unemployment levels. Now, the UK’s economy remains sound despite slowing growth, while interest rates and unemployment are low and a shortage of new homes being built is thought to help underpin current valuations.

But Howard Archer, chief economist at Global Insight, said there was a growing risk of “distressed sales” as unemployment has begun to rise and as millions of homeowners are forced to remortgage on higher rates.

He forecasts house prices to fall by seven per cent in 2008 and nine per cent in 2009, although he warns that this is fast becoming an optimistic view.

He said: “It now looks more likely than not that house prices will suffer double-digit falls both this year and in 2009, given serious buyer affordability constraints, limited and often more expensive mortgages available due to ongoing tight lending conditions, a deteriorating economic outlook and reduced prospects for further interest rate cuts in the near term at least.”

Partly the problems in the mortgage market have been caused by a crisis in confidence within the banking sector and the Bank of England has been working hard to try to help ease this, which would enable lenders to again raise money by selling on their mortgages and therefore stabilise the market.

It is thought that a combination of a slowing property market and easing in credit conditions will begin to see the lending clampdown loosen and prices react in response.

This week’s BBA mortgage figures already offered a glimmer of hope that the mortgage market had not ground to a halt, as some feared. And economist Allan Monks, of JP Morgan, believes price falls will begin to slow down.

“With lenders redesigning their products and mortgage provision moving back to some semblance of normality, it seems reasonable to assume that the pace of price declines will moderate as we move into the second half of the year,” he said.