Ah, the cycle of life. One generation of bankers retires and another comes along to make the same bonehead mistakes. The new guys start out with the best of intentions, of course, and for a while they keep to the straight and narrow. But the lure of empire building and/or the next performance bonus eventually wins out, and they, like their predecessors, end up piling into the bubble du jour just as it’s about to pop.

Today’s classic example is Bank of America, which has, over the years, melded various superregionals into a national consumer banking powerhouse. And now, with American households more indebted than ever before, what does BofA do? It spends $35 billion to buy credit card giant MBNA. That alone would tell you that the consumer finance cycle is about to turn. But wait, it gets better. On January 9, BofA received regulatory approval to start running its own real estate development business. Not just lending to builders, but actually building, owning and operating hotels and office towers.

For a sense of how this will end, a little recent history is helpful. Let’s begin with mid-1980s New England, where the Reagan military buildup was funneling billions into the region’s defense contractors, sending home prices through the roof and igniting an office building frenzy. In a rational world, local banks would have seen this for the temporary geopolitical phenomenon that it was and leaned against the wind by tightening their lending criteria or diversifying out of real estate. But they did the opposite. Between 1983 and 1989 real estate loans rose from 25% of New England bank assets to 51%.

And then everything fell apart. As the tide of the cold war turned in America's favor, military spending began a steady decline. New England defense contractors and local governments fired their recent hires, office vacancies soared, rents plummeted, and builders began defaulting. 16 Northeastern banks failed in 1990, 52 in 1991, and 43 in 1992.

While New England bankers were overindulging in real estate, their Wall Street counterparts were throwing a junk bond party. As the “high yield” boom got going in the mid-1980s, a handful of investment houses led by Drexel Burnham Lambert made fortunes finding targets for raiders and then selling the resulting junk bonds to mutual funds and S&Ls. It was a great business, with nice fat fees and relatively little risk (for the banks, at least. For the employees of the overleveraged companies and the buyers of the bonds, the risks were lethal).

But as things really got going, deal fees ceased to satisfy. Bankers in search of ever-bigger payoffs began funding the leveraged buyouts they facilitated. Called bridge loans, the deals worked like this: Say a boring company that had no business doing an LBO wanted to issue a billion in junk bonds to enrich its existing owners. And say an investment bank wanted the associated fees but couldn’t guarantee that the bonds would sell immediately. A rational banker would have listened to the market (which was saying the bonds weren’t that attractive) and recommended a more conservative amount leverage, or passed on the deal altogether. Instead, banks began lending their clients money up front in order to get the deal done, using their own capital to form a bridge between an LBO's conception and its completion.

The trend peaked with the LBO of Ohio Mattress, an Old Economy company if ever there was one. At the time, I was a newly-minted junk bond analyst and this was one of my first deals. At 11 times EBITDA (amazing the things you remember…I couldn’t tell you what I had for lunch yesterday but the Ohio Mattress deal is still fresh) the valuation seemed ludicrous. Meanwhile, in order to get this dog out the door, the underwriting investment bank, First Boston, had lent Ohio Mattress something like $500 million, in effect buying the junk bonds from the company before the offering. The idea was that we (the gullible mutual funds) would buy the bonds at ridiculously rich prices, and First Boston would get its money back, plus an eight-figure fee.

It didn’t work out that way, because the music stopped before the deal was priced. First Boston was stuck with massive loans to a crappy company, and nearly went under. Kidder and Shearson would have failed if they weren’t rescued by deep-pocketed parent companies, and Drexel actually did fail. Another brief digression: A couple of weeks before it died, Drexel mailed out invitations to its annual “predators ball.” The ball didn’t happen, but the invites became collectors’ items. I sold mine for $100 to another firm’s trader.

Now back to the present, where the memory-challenged people running America’s banks are piling into consumer finance. Led by BofA, they’re expanding their mortgage departments, buying up credit card companies, and now actually building and owning office buildings. Bridge loans are even back in style on Wall Street: Merrill Lynch just opened a $655 million fund devoted exclusively to the practice, and according to one press account, “Other companies such as Lehman Brothers and Smith Barney...are rapidly attempting to follow suit.” The result, if history is any guide, will be a bloodbath.

But this bloodbath is likely to be epic. Where the two 1980s examples involved niche markets, today’s consumer/mortgage bubble is national—global, when you consider all the “investment grade” asset-backed securities that U.S. banks now sell to foreign investors. And the institutions making the worst mistakes dwarf the regional banks and junk bond houses of the 1980s. When they go, they’ll take the rest of the economy with them.

Full disclosure: I’m short a long list of big U.S. banks, mortgage lenders, and home builders, and you should be too.

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