Three million homeowners, or more than a fifth of households, could end up in the trap of negative equity, with mortgage debts larger than the value of their property, as house prices continue to plunge, new City estimates show.

Bank of England calculations that the numbers caught in negative equity could soar from about half a million at present to 1.2 million by 2011, are seen as too optimistic in the bleakest assessment yet of the threat.

Michael Saunders, of Citigroup, says that the Bank's estimates are too optimistic since they are based on a survey of households where homeowners are asked for details of their own debts, financial assets and property value. Mr Saunders points to previous Bank research which showed that individuals tend to overstate the value of their homes by up to 20 per cent, and understate debts by 10 to 15 per cent.

Adjusting for this bias, he calculates that a likely further drop of 15 per cent in house prices — on top of the 15 per cent slide over the past year — will leave between 2.5 and 3 million homeowners in negative equity. This would exceed the peak of 1.8 million, the number of people who were in this predicament in the early Nineties.

Mr Saunders gave warning that negative equity will leave millions of people reluctant to spend and deepen the painful, consumer-driven recession that most of the City now expects. “Widespread negative equity is likely to exert a lasting drag on spending as households save more, while also hitting the credit quality of lenders' assets and adding to the caution over high debt levels among both lenders and borrowers,” he said.

Worries over the scale of the housing slump were reinforced on Friday as the latest snapshot of conditions in London from Knight Frank, the estate agent, showed that prices in the prime residential areas of the capital fell by a record 3.9 per cent last month.

The City is on alert for Thursday's interest rates verdict from the Bank's monetary policy committee (MPC). A cut is seen as a certainty, with a majority of economists expecting a further half-point reduction to match last month's emergency move, and take rates to 4 per cent.

Some believe the MPC will be bolder, and order an unprecedented reduction of 0.75 percentage points, or even a full point as it steps up its efforts to prevent a deep recession. On the same day, the European Central Bank is also expected to cut eurozone interest rates by a half-point.

Pressure on the MPC to deliver an aggressive rate cut will be increased this week as a spate of dire results from corporate Britain is expected to emphasise the impact of the economic downturn. First-half sales at Marks & Spencer are tipped to be the worst for three years, while British Airways' half-year results on Friday are expected to show the impact of sliding demand and the past surge in oil prices.

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