There are times when it is better not to peer too closely into the over-the-counter derivatives market, and for Britain's homeowners, now is such a time.

Although the most closely followed barometers of house-price inflation, such as the Halifax, Nationwide and Hometrack surveys, are pointing towards flat or modestly rising prices in 2008, the fledgeling UK residential property derivatives market is telling a very different story.

The Tradition Future House Price Index — a tradeable forward curve on which bankers, hedge funds and property developers bet in a minimum deal size of £5million — is predicting a fall of 10.5 per cent next year, or a fall from a current average price of £194,258 on Halifax data to £173,861 next December. To put that in context, the steepest annual fall over the past two decades — in 1992, the peak of the early 1990s housing recession — was 6.1 per cent.

That forecast may be unsettling to a recent homebuyer, but it will be especially troubling to anyone still holding shares in Britain's hard-pressed housebuilding sector — which, having fallen 48 per cent this year, almost all of that in the past six months, is already one of the stock market's worst performers.

The sector's problem is that housebuilders' profits are highly geared to changes in selling prices — a reflection of the fact that, although fixed costs are relatively low, about three-quarters of the purchase price of a house is accounted for by land, materials and labour costs, which will rise as a proportion of sales and so put pressure on margins.

Research published this week by Citigroup calculates that every 1 per cent fall in UK house prices will hit earnings across the sector by an average 6.6 per cent. On that basis, the 10 per cent fall predicted by the derivatives market would wipe out two thirds of the average housebuilder's profits — less in the case of the higher-margin operators, such as Berkeley and Bovis Homes, but considerably more in the case of their lower-margin rivals, such as Taylor Wimpey, which Citigroup estimates will make a sub-sector return on sales next year of 9.3 per cent. Indeed, a 10 per cent fall would wipe out all the company's forecast operating profits from the UK next year.

Not that Citigroup is anywhere near as gloomy as the clients of Tradition. The US investment bank believes that UK house prices will fall 3 per cent next year — which would still mark their first retreat in more than ten years — and remain flat in 2009. That alone would hit its profit forecasts by up to 18 per cent. However, coupled with Citigroup's expectation of an accompanying 10per cent fall in the volume of house sales, the effect is more dramatic: an average 27 per cent fall in forecast earnings for 2008, and a 30 per cent fall for 2009.

However, profits are only part of the story. The requirement to build up substantial land banks, as well as the seasonal ebbs and flows in stock positions as houses are built, completed and sold, means that the sector's balance sheets should also be taken into account. Here, Citigroup highlights those housebuilders for which the ratio of operating profits to interest payments is the lowest. For Berkeley, which is now more than halfway through a programme of returning capital to shareholders, forecast interest cover is a healthy 31times. However, for Barratt Developments — which yesterday dropped out of the FTSE 100 — and Taylor Wimpey, that ratio will fall to about four times next year. Given that most banking covenants are pegged on a minimum cover of three times, Citigroup suggests that the two could start to get close to their lending limits if a fall in house prices more severe that expected is accompanied by a decline in volumes.

The question for investors is the extent to which this gloom has already been priced in. Perhaps the most encouraging signal is that housebuilders are now exceptionally cheap by historic standards in relation to net asset values. Share prices in the sector have not traded below a ratio of 1.1 times net asset value over the long run — they peaked at nearly 1.7 times last year — and so the fact that they now trade at a discount is clearly encouraging. This is all the more so given that it is considered highly unlikely that British housebuilders will face the sort of asset writedowns that have troubled their American peers. Even a 10 per cent fall in house prices next year is not expected to force housebuilders to take provisions against the value of their land.

However, on the basis of earnings multiples, stock market valuations are far less compelling. Using Citigroup's downgraded 2008 profit forecasts, the sector is still trading at nine times, against the trough of six times seen earlier this decade.

Neither are dividend yields especially attractive — despite their benefit from tumbling share prices and a move towards higher payout ratios in recent years. Stripping out Berkeley, which pays no dividend, the sector's prospective yield for 2008 is 6.6 per cent, less than that widely available in the banking and commercial property sectors.

So, although the likes of Bellway, Berkeley and Persimmon are among those better placed to ride out a period of house-price deflation, there are few good reasons to buy the sector while the credit crunch persists. Further UK interest rate cuts in January or February ahead of the important spring selling season would help to turn sentiment in the stock market. The big-ticket punters in the derivatives market are likely to prove harder to convince.

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