American financial markets got a dose of reality yesterday, a wake up to the true state of the troubled housing sector: it’s bad and is going to get worse. It was news that cooled the celebrating of the Fed’s half a per cent rate cut. New figures showed that home building permits fell to a 12-year-low (they measure future intentions) as they dropped 5.9% to an annual rate of 1.307 million.

Actual new house starts hit the lowest figure since 1995, falling 2.6% to an annual rate of 1.331million units; more worryingly, the slow down in housing has spread out of California, the south, Florida and parts of the Midwest to the populous North East where starts fell a very sharp 38% in August.

As permits are still lower than starts, the new housing market is still facing further falls. But new homes only account for around 15% of the US home market: existing home sales the other 85% and that’s where the subprime mortgage crisis is being felt the most. It’s where foreclosures are biting. According to a new study released yesterday in America, the next few years will see more than three-quarters of the nation’s housing markets suffer some decline in home prices.

According to the updated analysis of the US home market from the Moody’s Economy.com website, many markets will see double-digit falls: declines will exceed 10% in 86 of America’s 379 largest housing markets. And 290 of the cities will experience price drops of 1% or more. Offsetting this was news that US consumer inflation followed producer inflation lower in August, meaning that the Fed’s cut had some justification on grounds of economic fundamentals, but with commodity prices rising and oil at record levels, what will happen this month and over the rest of the year?

At a US House of Representatives hearing in Washington, one of the most respected US economists and home price forecasters, Robert Schiller of Yale University, warned that the US faces fresh economic shocks on the scale of the current credit squeeze if US house prices continue to fall. Meanwhile, Fed chairman, Ben Bernanke is due to front the US Congress tonight, our time, to testify. The rate cut will make his job easier, but the gloomy outlook for the housing market will be where he will be tested by forecasts from people like Robert Schiller, who is in the same league as the Fed chairman insofar as economists with clout are concerned.

Mr Shiller said he feared “the collapse of home prices might turn out to be the most severe since the Great Depression”. He’s got a very solid track record, having designed the respected Case-Shiller house price index (its now considered the most authoritative in the US) and predicted the bursting of the dotcom bubble.

Mr Shiller was quoted in US media reports as saying that it was “difficult to predict the depth, duration and all of the consequences” of the worsening housing slump. He said that while there had been a focus “on lax and irresponsible lending standards, I believe that this loss in housing value is the major ultimate reason we see a crisis today.”

His warning comes on top of one from former US Federal Reserve chairman, Alan Greenspan, who told the London Financial Times earlier in the week that double-digit falls in house prices from their peaks would not be surprising. He said that a fall in house prices on that scale would be unprecedented in US history and would have an economic cost several times greater than the meltdown in the subprime mortgage market that triggered the current financial crisis.

But it’s just not the US where worries are growing. In Britain, which is grappling with the bailout of big home lender, Northern Rock (more than $US200 billion in mostly mortgage based assets), housing prices have started easing for the first time in three years. The credit market squeeze has already hit inner city property values in London and reports last week warned of a slowdown or easing tone appearing in other markets.