The way this happened with subprime mortgages is similar to what is going on now in lending to private equity buyouts.

In subprime mortgages, the initial success during the real estate boom caused lenders to relax their standards and loosen their requirements for documentation. In 2003 and 2004, defaults were unusually low and investors who bought the mortgages did well and wanted more. Lenders lowered their standards by

• Making loans to more people with low credit ratings;
• Demanding less documentation of income and assets;
• Allowing borrowers to finance 90% or 100% of the purchase price without requiring them to buy private mortgage insurance;
• Continuing to sell mortgages with teaser rates that reset upward; and
• Coaching borrowers of low-documentation loans to inflate their incomes even if they couldn't afford the first mortgage payment.

The same thing could be happening now with lending to private equity firms. How so?

• Corporate bankruptcies are expected to surge - According to a November 2006 report by the American Bankruptcy Institute and Dow Jones' Daily Bankruptcy Review, corporate bankruptcy filings, subdued by the high availability of credit in recent years, should hit courts within the next six to 18 months. The survey said 70.7% of 90 respondents expect "the next big wave of restructurings" is on its way. Loan default rates have stayed lower than predictions so far this year. However, the bankruptcy experts who contributed to the report, including lawyers, bankers and investors, expect defaults will soon move back up, leading to a greater number of filings.
• The smart money is betting that private equity will be a big source of corporate bankruptcies - Goldman Sachs seems to see a profit opportunity here. In June, it hired James H. M. Sprayregen, one of the world's leading experts in bankruptcy. In all likelihood, Sprayregen will be working on busted deals originated by private equity firms because their business is growing so fast. Private equity firms -- that buy companies using a sliver of cash and a ton of debt -- account for 26% of all U.S. mergers this year -- paying $320 billion to take out U.S. companies, up 115% from 2005.
• As with subprime mortgages in 2003 and 2004, lending standards to private equity firms are now loosening - Yesterday I spoke with a banker who told me of a disturbing trend in lending to private equity firms. The terms of bank debt and buyout bond contracts are loosening considerably in order to increase the volume of these lucrative deals. In a more conservative lending environment, borrowers are required to maintain specific levels of debt to equity and cash flow to interest and other bank charges. These terms give lenders early warning of a borrower's inability to pay back the money they've borrowed. Now, my banking source tells me, a growing number of private equity firms are able to borrow money without these financial terms in their borrowing contracts.

The point? Private equity firms are getting the subprime borrower equivalent of low-documentation loans. If the bankruptcy experts are right, the lenders to these deals will be in rough shape in the next couple of years.

A similar thing happened in the 1980s when I worked in banking. During the 1980s commercial real estate and leveraged buyouts boomed with help from the banks. Due to the lucrative fees, banks loosened their lending standards. When the economy slowed, the loans went bad, banks failed, and bankruptcies soared.

My observation is that initial profit in an asset class attracts lots of other people to pile in -- leading to very rapid growth accompanied by lower lending standards. And these things never end well. To paraphrase Mark Twain, history doesn't repeat itself but sometimes it rhymes.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College.