Not to beat a dead horse, but the European debt crisis has been an ugly reminder that putting a lid on problems doesn’t mean they go away. In fact, the lid may just hide the nasty stew brewing underneath.

It has also confirmed what investors without short-term memory loss already knew; the stew is always thicker than initially led to believe.

I lost track of how many Greek bailouts fell through just days after they were “approved.” On February 11, 2010, CNBC reported that the “European Union throws a big fat Greek bailout.” At that time, the bailout was to be for $41 billion.

On April 24, the Wall Street Journal reported that “Greece asks for a $60 billion bailout.” The actual bailout Greece received on May 3 was $146 billion. But wait, there’s more:  On May 10, an additional $1 trillion was made available to other ailing European nations.

The Plot Thickens – Scene 1

Europeans, however, did not invent the concept of rosy estimates. Corporate America was one step ahead. In October 2007, Citigroup estimated to take about $2.2 billion in mortgage related write-downs.

In November, the amount was increased to $11 billion. In January 2009, Citigroup’s fourth quarter results included an $18.1 billion write-down. By April 2009, the write-down tally was estimated to be around $100 billion.

The Plot Thickens – Scene 2

There are plenty of other examples – Fannie Mae, Freddie Mac, AIG, etc. – but one of the most popular is Lehman Brothers.

When Lehman released its preliminary Q3 2008 earnings report on September 10, 2008, Lehman claimed that their core business is fairly sound and that any declines in core business can potentially be due to the swirling rumors about their stability.

Richard Fuld, former CEO of Lehman Brothers, stated their goal of “reinforcing our focus on our client-facing businesses and returning the firm to profitability.”

On September 9, Standard & Poor’s put Lehman Brothers long-term ‘A’ rating on watch for a possible downgrade. As it turned out, the long-term rating quickly became a moot point. On September 15, six days later, Lehman filed for bankruptcy.

Asking the Right Questions

Many wonder, what caused Lehman’s demise when the real question remains; how was Lehman able to disguise its shaky financial condition for so long? As harsh as it may sound, Lehman and many other financial firms had been deceiving investors.

Repo 105 – How Lehman Almost Got Away

The bank-appointed examiner’s report on Lehman Brothers released in mid-March 2010 revealed some startling accounting maneuvers. Lehman took advantage of Repo 105, an accounting trick that hid its leverage. In a nutshell, here’s what happened:

The Repo market is a way for banks to borrow money against collateral, i.e. a bond. If the borrower goes bankrupt, the lender gets to keep the bond. If the borrower repays the loan as planned, the lender gets to keep a fee and interest. In reality, the bank isn’t really selling a bond, its simply borrowing money. But Lehman wanted to hide how much money it was borrowing.

To do just that, Lehman would sell a bond that was worth $105 on the repo market for $100 (Lehman put up collateral equal to 105% of the cash it received, hence the nickname Repo 105). For accounting purposes, Lehman got the cash infusion which was used to pay off debt. Then, after it had issued its quarterly report, Lehman would borrow more money to repurchase the bond.

Because of those and other deceptions, the ETF Profit Strategy Newsletter considered the financial sector (NYSEArca: XLF) “a down-ward spiral with no stop-loss provision” in September 2008.

It’s nearly forgotten now, but within six months of that assessment, the Dow Jones (DJI: ^DJI), S&P 500 (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) tumbled some 50% and arrived at the newsletters bottom target range of Dow (NYSEArca: DIA) 6,000 – 6,700.

Even though fundamentally nothing had changed, the ETF Profit Strategy Newsletter issued a Trend Change Alert on March 2, 2009. As per the alert, the Dow was expected to rally as high as 10,000, with the top being marked by extreme optimism and a "the worst is over" sentiment.

At the time, a 50% rally from the March lows was viewed as unrealistic, even impossible. As it turned out, the Dow 10,000 prediction was too conservative. But the April highs were certainly accompanied by a "the worst is over" attitude.

Artificial Earnings - Inflated Prices – Stock Market Crash

Just as Lehman used Repo 105 in 2007/2008 to hide its true financial condition, financial corporations use a revised rule 157 to lull investors into a false sense of security.

It would take several pages to explain the economic ramifications of Rule 157 and its April 2, 2009 revision, but we’ll touch on the major points in the paragraphs below (a full explanation is available in the June 2010 ETF Profit Strategy Newsletter, page 13).

The new rule 157 allows banks to hide their non-credit losses. This means non-credit losses are NOT included in the bank’s earnings. As such, the earnings numbers banks (NYSEArca: KBE) have reported are as valid as Tiger Woods’ marriage wows. Here’s a simplified example:

Bank A holds a securitized pool of mortgage-backed assets (MBA) originally valued at $100. After modeling the future cash flow of the pool, the bank projects it will ultimately collect $95. The credit loss is $5. However, due to economic factors, the MBA pool is currently worth only $40, a $60 loss. The difference between the two calculations ($60 - $5) is the noncredit loss - $55.

How Big Is the Problem?

How high are such noncredit losses? No one knows for sure, but a look at the FDIC’s list of failed banks provides a scary glimpse of what may be ahead. Frontier Bank was closed by the Washington Department of Financial Institutions on April 30, 2010. According to the FDIC’s website, Frontier Bank had approximately $3.5 billion in totals assets and $3.13 billion in total deposits. Subtracting the liabilities from the assets, the bank’s book of business should be worth around $370 million.

The FDIC’s website states the following: “The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $1.37 billion.” Where does the $1.74 billion difference come from? Apparently the bank’s actual assets were less than reported, 50.3% less.

There are plenty more examples available on the FDIC’s website, in plain sight of investors. As a point of reference, Bank of America, Citibank, JPMorgan and Wells Fargo have about $7.5 trillion in combined assets. Assuming those banks are overvaluing their assets by just 25%, about $1.8 trillion of unrealized losses could yet be waiting to hit the fan. Imagine what that will do to stock prices?

A Negative Feedback Loop

Of course, artificially engineered earnings are just one of the many problems the U.S. stock market (NYSEArca: VTI) faces. In fact, the market is hyperventilating; at least that’s what internal signs are conveying.

Breath and volume during most of the 14-month rally has been anemic, as much as 40% below historic averages. For 2010, 77 of the S&P 500 (NYSEArca: SPY) components are down more than 20%, and despite humongous amounts of government stimulus the economy is still lagging.

In times like these, it behooves us to broaden our horizon and look beyond the daily news served by the financial media and dig deeper to avoid surprises such as the 2000 tech bust (NYSEArca: XLK) and 2007 mortgage bust.

The ETF Profit Strategy Newsletter offers monthly out-of-the box analysis in addition to bi-weekly updates that provide target and safety levels along with corresponding profit strategies. The recent forecast isolated the one support shelf that once broken, will bring much lower prices.