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Stephen Koukoulas, who served as a senior economic adviser to Julia Gillard in 2010-2011, said it is realistic to think there could be a national decline of 20 per cent in house values.
“When markets go up at an incredibly strong pace … there is a real risk that we do see something of a correction,” he said.
Sydney median prices jumped 17.8 per cent for houses and 9.5 per cent for units during the 2014/2015 financial year, while Melbourne prices grew 11.2 per cent for houses and 2.4 per cent for units, according to CoreLogic RP Data.
Mr Koukoulas said a 20 per cent correction would wipe out about $1.1 trillion in housing value, which would cause a big drop in consumer confidence and make banks less likely to lend.
“The global experience over the last decade in the US, UK, Ireland and Spain tells us that once these things do turn, they can be very nasty,” he said.
“It's still a low probability. It's less likely than more likely, but with each rise in the price every week or every month and the shortage of property for sale, it appears that this risk just gets higher.”
Mr Koukoulas said that while house price growth cooled late last year, he’s become concerned that the market has become more active in 2015.
“I don't mind markets going up a bit… but a point comes where this is just getting silly, this is now getting really overcooked, and I think we're in that territory now,” he said.
“It's obviously been an issue that's been on some people's minds for many years, but I've not been terribly concerned about house prices until the last three to six months.
“Yes, they're high, yes there are issues there, but it's just really this last three months or so that's caused me to think, 'Gosh this is a problem'.”
Mr Koukoulas said that the size and timing of any correction would be strongly influenced by any increases in interest rates and unemployment numbers.
One thing that could take heat out of the market is the record amount of new housing that’s being built, Mr Koukoulas said. A reduction in investor lending would also help, he added.
According to new banking statistics for May, three of the big four banks are growing their investor lending books by more than the 10 per cent per annum recommended by the regulator, APRA.
NAB posted annual growth of 14.1 per cent and quarterly growth of 3.5 per cent. ANZ had growth of 10.6 and 2.6 per cent, Westpac had growth of 10.0 and 2.2 per cent and Commonwealth Bank had growth of 9.9 and 3.0 per cent.