Only five years ago, unemployment in Ireland stood at 4%, its budget enjoyed a massive surplus, and the government could borrow money at dirt cheap prices. As Ireland became one of the richest countries in the world, people flocked to its shores, eager to earn a disproportionately above-average living. Irish banks raked in cash, investment banking boomed, and the government did all it could to ramp up growth, whether by eliminating trade barriers or dramatically lowering the corporate tax rate. The Irish had gone from crazy poor to crazy rich, and money flowed like water.

How quickly things have changed!

What the heck happened?
According to Michael Lewis' Vanity Fair article, roughly more than one-fifth of Irish workers were employed constructing houses during the boom. The industry had enlarged to equal about 25% of the country's GDP. (For context, from 2004-2007, construction accounted for about 4%-5% of U.S. GDP.) Since 1994, the average price for a Dublin house had risen by more than 500%, with little logic behind the enormous spike in prices.

To make matters worse, most of the construction was funded by Irish banks such as Anglo-Irish Bank, Allied Irish Banks (NYSE: AIB), and the Bank of Ireland (NYSE: IRE). If and when the nascent real estate bubble exploded, and prices dropped back down to earth, losses would mount significantly at the banks, placing the entire industry at risk.

Eventually, that scenario came to pass. Market sentiment eventually turned, buyers dried up, banks stopped lending at their previously ridiculous levels, construction stopped, the economy faltered, people lost their jobs, spending froze, and Ireland essentially went to hell in a bucket in a quick one-two real estate punch.

Where are we now?
Anglo Irish Bank, once at the epicenter of the housing-lending spree, has since been disbanded and bailed out for billions and billions of dollars. The government has taken a majority stake in both Allied Irish Bank and Bank of Ireland; four of the six top banks have been fully or mostly nationalized. All told, despite numerous attempts at quelling public fears that, like Greece, it would have to go to the IMF cup-in-hand, Ireland eventually succumbed to the pressure and accepted a whopping $113 billion aid package from the EU and IMF.

The rest is sadly predictable. Like Greece, Ireland has endured sovereign debt downgrades, the sort of falling bank shares that National Bank of Greece (NYSE: NBG) suffered, and a government trying to trim enough spending to save its banks without cutting budgets so deeply that it wrecks its economy.

Stress tests ensued, as EU finance ministers clamored to warrant another Greek-style abandonment of collateral standards in order to lend to Irish banks, despite the epic challenges facing those very institutions. The stress tests confirmed what most people already feared: Bank of Ireland supposedly needs more than $7 billion, and overall, the six biggest banks reportedly need around $33 billion, according to The New York Times.

Perhaps making matters worse, the European Central Bank has decided to raise interest rates for the first time in almost three years. That move possibly signals a recovery for richer countries such as Germany, but it also may curb any attempt at a comeback for Greece, Ireland, or Portugal -- which has now also officially asked for a bailout.

The blows keep coming
Allied Irish just reported an enormous loss of more than $14 billion for 2010. More than one-third of its retail loans in Ireland were either vulnerable or impaired, and its overall non-performing loans as a percentage of total loans have skyrocketed from 1% in 2005 to 24% in 2010. Now the bank must face some of its most toughest challenges yet, as it cuts roughly 2,000 jobs over the next two years. That figure represents about 15% of its Irish workforce. To try and shore up whatever cash it could, AIB sold its 70% stake in Polish Bank Zachodni WBK to Spanish banking giant Banco Santander (NYSE: STD) late last year.

The Foolish bottom line
I don't expect anything to get any easier for the Irish banking sector. These types of bubbles don't puncture quickly, and their repercussions typically linger for years. If you're a contrarian investor looking at one of these banks as a potential cheap play, I'd encourage you to stay far away.

UBS recently estimated that Royal Bank of Scotland (NYSE: RBS) may need more than a few billion dollar to cover loan losses from its Irish portfolio, and Lloyds (NYSE: LYG) will have to boost its provisions as well. Although the latest estimates won't be large enough to substantially affect their bottom lines, it's a good idea to watch out for banks with a lot of Irish exposure. Right now, there's no good news coming out of Dublin, and I don't expect any for the foreseeable future.

Interested in watching these banks closely to get the latest news and commentary?

Both Jordan DiPietro and the Fool own shares of National Bank of Greece. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.