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First-time buyers face a downward spiral in the value of their homes with up to 10 per cent facing negative equity this year, according to a report by Morgan Stanley.

Figures from the investment bank's latest research on mortgage markets and the wider economy have revealed that 1.2m Britons could see the value of their properties decline by ten per cent in 2008 and a further five per cent in 2009, representing a negative equity of £164bn.

The outlook was more pessimistic in a bear market, forecasting as much as a 25 per cent fall in the value of houses over two years, effecting more than 2m homeowners. However, the investment bank recognised the likelihood of this happening was slim, putting the probability at approximately 30 per cent.

The report called on investors to remember the key distinctions between the structure of the mortgage market today and that of the early 1990s, the report said lenders currently lacked the protection of mortgage indemnity guarantees, which had reduced bank losses by 33 per cent in this period. It added that insufficient bad debt reserves and the pro-cyclical nature of Basel 2 makes matters worse for homeowners today.

Charles Bean, chief economist at the Bank of England, warned homeowners last week that house prices could continue to fall this year. He said the reduction in the availability of mortgage funds "seems likely to keep activity subdued and put further downward pressure on house prices relative to earnings".

However, David Miles, chief economist for Morgan Stanley, said that in the context of significant house price rises over recent years, negative equity would not have such a harsh impact. He said: "A ten per-cent fall in house prices this year - with a smaller fall next year - might sound dramatic. But as a possible scenario it should be seen in the context of the very large increases in prices in recent years. If we did see this scenario materialise it would mean that average house prices were back to where they were at the start of 2006."

He added: "And although it might generate a substantial number of people with a mortgage larger than the value of their house, the great majority of them would have a small amount of negative equity. The key factor is that unlike in the early 1990's I do not think it likely that mortgage interest rates will go up substantially for the great majority of people. This is why a re-run of the early 1990's, in terms of the numbers of people who cannot pay their mortgages, and in terms of a recession in the UK, is unlikely.”

The Council of Mortgage Lenders rejected the forecast, predicting a rise in the value of houses this year. Sarah Robson, spokesperson at the CML, said: "We do not agree with the prediction or idea there will be a ten per cent fall. We think you are looking at a dramatic scenario that is unlikely."

Lesley Mcleod, communications director to the British Bankers' Association chief executive Angela Knight, questioned the wider impact of negative equity, pointing instead to the psychological effect on homeowners. She said: "Negative equity has a lot to do with a 'feel good' factor in relation to the money and for the most part people buy a house to live in and it is not so much an investment - so it does not have that kind of knock-on effect on the banking industry."

Commenting on previous periods of negative equity, she said: "House negative equity had more to do with how you felt about your money, than what you did about it. It made you feel less secure and less wealthy, but the actual effect, if you were not moving home, was minimal."

Where mortgage prices are today:

Source: Bank websites for up-to-date mortgage pricing, Morgan Stanley Research