It wasn't just the housing market where banks were injecting silly amounts of money without fully understanding the risks. The leveraged buyout business was another favourite for reckless bankers.
The idea of a leveraged buyout is straightforward. A speculator raises huge money, either by issuing junk bonds or taking out loans, and then uses the money to take over a controlling interest in a target company. The speculator doesn't actually put up much of her own money -hence the title leveraged. Therefore, the speculator needs a ready source of credit. Until the credit crunch rolled into town, banks have been all too ready to provide money for these highly risky projects.
The leveraged buyout business has a long and grim history of financial failures. Towards the end of the 1980s, many buyouts proved to be highly unprofitable, leading to a number of horrific bankruptcies.
The chart above illustrates the explosive growth of leveraged buyout loans. In order to make the years comparable, the half yearly amounts have been inflation adjusted. The business peaked during the first half of 2007, and it has been sliding ever since. The stock of new loans during the first half of 2008 has fallen back to the level of 2004. It is likely that the market will have totally evaporated by the end of this year.
Leveraged buyout loans raises an old issue - bank supervision. Why did regulators allow banks to get involved in such a dangerous business?