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The second half of 2007, marked as it was by the failure of Northern Rock, was the most miserable six months the housebuilding industry has known for a long time. And so far 2008 has been even worse: Persimmon is to close offices across the country, major housebuilders are putting the squeeze on their suppliers, and revenue is falling at nearly all the big firms. Investment bank Dresdner Kleinwort put out a research note entitled simply: 鈥淗ousebuilders: Abandon the sector鈥�. Although some see this pessimism as overdone, there is no arguing with the facts: this time last year Taylor Woodrow was worth 拢2.45bn and George Wimpey 拢2.55bn. Today the combined company is worth just over half what either was on its own.

It鈥檚 about to get really serious 鈥�

The period from the end of January to Easter is traditionally the strongest selling period of the year, which means that we are about to find out if last autumn鈥檚 housing market downturn melts in a wave of spring optimism, or deepens to a genuine slump.

And the stakes couldn鈥檛 be higher, both for the housebuilders themselves and for the government. According to Citigroup, housebuilders will lose two-thirds of their profits if prices fall steeply. And for the government the situation is just as grave. Gordon Brown has staked his credibility on increasing housing output 鈥� the target is to build 2 million homes by 2016. But with all commentators predicting that housing output will fall, these targets are going to get harder to meet.

Roger Humber, strategic policy consultant to the Home Builders Federation (HBF), is in little doubt as to the depth of the crisis. 鈥淚t鈥檚 quite the worst position we鈥檝e been in since the nineties,鈥� he says. 鈥淚t鈥檚 clearly very bad.鈥�

There is plenty of evidence to support his view. Figures collected by the HBF from its members show that the number of firms reporting rising reservations has fallen to its lowest level since 1992.

And it is not just a problem of fewer customers. Once customers reserve properties, they are much more likely to have their mortgage declined by the bank because of the tightening of lending criteria caused by the credit crunch. Mike Killoran, group finance director for housebuilder Persimmon, says this fact has made the number of cancellations rise from 20% to 30% of reservations. 鈥淲e鈥檙e working doubly hard to replace sales that we鈥檝e lost with new sales,鈥� he says.

All the major indices report that house prices have been falling for the past three months, with a further fall of between 0% and 3% predicted for this year. The first figures for January show little sign of bucking this trend 鈥� online estate agent Rightmove last week reported prices falling again.

A report by Citigroup in the first week of this year showed just how important these marginal falls in prices are for housebuilders 鈥� it calculated that for every 1% drop in house prices, profits fall by 6-7%.

Trends are at least variable according to region and type of development, with sales in London holding up well so far. However, for developers of flats outside the capital, the market has disappeared, along with the buy-to-let investor. Already Taylor Wimpey has been forced to pull its Green Bank development, which would have provided Leeds city centre with 300 flats, and there are rumours that many similar developments are facing a similar fate.

Mark Ryder, the chief executive of public鈥損rivate joint venture developer Isis, says: 鈥淲e鈥檙e seeing the death of the town centre product that鈥檚 become so ubiquitous in the past five years. There are going to be big losers 鈥� people who鈥檝e simply built the wrong kit.鈥� And most assume that some companies that bought land or concluded onerous section 106 deals at the top of the market last year will soon be in trouble.

So what should they do?

Housebuilders react to a slowdown in a number of ways (see, David Pretty above), but first they raise sales incentives. Persimmon鈥檚 Killoran, for example, says his firm has increased estate agents鈥� average cut from 3% to 4% of the cost of a home. The HBF reports that more than two-thirds of housebuilders have increased incentives in recent months. They will also attempt to cut costs (see Chain reaction box) and stop buying land. Housing associations will be able to take advantage as builders attempt to flog off difficult-to-sell homes and unwanted land.

The biggest impact, though, will be on the rate of construction. Faced with weak demand, firms concentrate on getting finished homes sold rather than building more. Persimmon鈥檚 Killoran says each of his regional teams meets and discusses sales in detail on a weekly basis. They make immediate decisions about whether to slow construction. Citigroup estimate that volumes will fall 10% next year. Humber, though, suggests it could be worse than that. 鈥淪tarts could go right down to the low of 2003, when we built just 120,000 homes.鈥� To put this in context, that figure is just half the government鈥檚 annual housebuilding target, and a 30% fall on last year鈥檚 volumes.

In addition, bank-funded developers may face the prospect of having their funding pulled because of the credit crunch. Jim Gill, chief executive of regeneration agency Liverpool Vision, says this is already happening to schemes in the city. 鈥淧reviously banks have funded schemes on a certain number of pre-sales. But now they鈥檙e saying, 鈥榃e鈥檙e changing the game, guys鈥�.鈥� Schemes that previously needed to sell 30% of units to secure funding may now need to sell 50%.

Even if funding is no problem, housebuilders may prefer to take their chances with the planning system and try to get a new permission, rather than risk building high-rise flats designed for an investor market that has profoundly changed. Gill adds: 鈥淭hey鈥檙e rethinking the mix and scale of development 鈥� it鈥檚 what you鈥檇 expect.鈥�

All of these factors together spell bad news for the government鈥檚 housing targets 鈥� particularly the move away from city-centre apartments. John Stewart, director of economic affairs for the HBF, argues it has only been by increasing development density that the government has managed to achieve any growth in housing numbers at all since 2003. 鈥淭he cutback in apartments will have an impact on housing delivery 鈥� it鈥檚 going to accelerate the problem,鈥� he says. Humber adds that an ever-increasing regulatory burden, particularly with the move to zero-carbon homes, will only serve to make sites less viable still.

But if falling starts is a problem for Brown, for housebuilders it can only mean one: more takeovers. With share prices so low, analysts say that mergers and acquisition activity is likely as buyers seek to pick up good firms at bargain prices. Willmott Dixon鈥檚 buy-back of social housebuilder Inspace, as well as Countryside chair Alan Cherry鈥檚 mooting the buy-out of the remaining half of the company, can both be seen as indiciations of the shape of things to come. Richard Kelly, a partner at City firm BDO Stoy Hayward, says the only question is how a takeover might be funded in the current financial climate. 鈥淲hat we might see is not trade mergers but the input of overseas funds, such as state-backed sovereign funds, which are looking for good asset-backed organisations. Clearly there are a number of mid-sized housebuilders who are trying to be bought.鈥�

Although nobody denies the long-term demand for new housing in the UK, the credit crunch has clearly posed housebuilders their biggest test in a decade. The next few weeks will give an indication of just how severe that test is going to be. Just don鈥檛 be surprised if by this time next year a few more familiar names have become history.