If you are like me, you miss the good old days when a handshake agreement was all you needed to seal a business deal. Somebody’s word was worth as much as a contract, in fact, it was a contract, an oral one.

No doubt, things have changed. And while you can still find businessmen with integrity on Main Street, you need a huge magnifying glass to find them on Wall Street.

After living through the sub-prime mortgage aftermath and the associated finger pointing, and after seeing huge bonus checks being paid by Wall Street firms for less than mediocre performance, we’ve probably become accustomed to Wall Street’s disregard for honest business practices.

Enron – The Legacy Continues

Enron and Lehman are two well-known scapegoats. After all, it’s easier for the Administration to shift the blame to an entity that’s out of business and unable to fund any future political campaigns.

But if you look around and read between the lines, you find cases of – let’s call it impropriety – going on right here, right now.

The Wall Street Journal just uncovered one issue that the ETF Profit Strategy Newsletter predicted months ago.

“BofA admits hiding debt” is the official headline. “Oops, we cheated accidentally on purpose” would describe the issue more accurately.

This issue is particularly interesting as Bank of America reports its earnings on Friday.

Omitting what’s Important

The implications from the WSJ article are that “banks are carrying more risk most of the time than their investors or customers can easily see.” When it comes time to reporting quarterly earnings, BofA found it appropriate to apply a little accounting trick, unintentionally of course.

WSJ reports that “though much smaller in scope, Bank of America’s accounting of the six trades is similar to what a bankruptcy-court examiner said Lehman Brothers Inc. did to make its balance sheet look better before it filed for bankruptcy in 2008.” Bank of America disclosed six transactions, also known as “dollar roll” trades that were erroneously misclassified.

Dollar rolls are deals in which mortgage-backed securities (MBAs) are transferred to a trading partner with a simultaneous agreement to repurchase similar – not the same - securities from the same trading partner (which was unidentified in this case).

To be allowed to categorize the transaction as a sale – thereby removing them from the balance sheet – BofA considered the trades to be similar. As it turns out, however, the securities that BofA repurchased had the same grantor and same coupon. They were not just similar, they were substantially the same. As such, the trade should have been accounted as borrowing not selling.

Unfortunately for BofA, the process of borrowing does not remove the obviously toxic assets from their balance sheets. Those so called unintended mishaps occurred for six quarters from from 2007 to 2009. The classification error involved more than $10 billion in repos.

Of course BofA did not volunteer that information. It was a required response to a courteous letter the SEC sent to 19 large financial institutions inquiring about their repo practices. Can you imagine what kind of information they’d get if the SEC dug even deeper.

From a $10 Billion to a $2 Trillion Problem

Before we discuss more than just the tip of the iceberg, let’s take a look at a few ETFs affected by accounting errors or financial engineering in the financial sector.

Of course there are the usual suspects such as the SPDR KBW Bank ETF (NYSEArca: KBE), the Financial Select Sector SPDRs (NYSEArca: XLF), the iShares Dow Jones US Financial Sector ETF (NYSEArca: IYF), and the Vanguard Financial ETF (NYSEArca: VFH).

There are short and leveraged ETFs like the UltraShort Financial ProShares (NYSEArca: SKF), Direxion Daily Financial Bear 3x Shares (NYSEArca: FAZ), Ultra Financial ProShares (NYSEArca: UYG), and the Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS).

Next to technology (NYSEArca: XLK), the financial sector is the single biggest segment of the S&P 500 (SNP: ^GSPC) and a big force in the Dow Jones (DJI: ^DJI). We’ve come to learn over the past few years, financials move the market – for better and for worse.

The above-mentioned dollar roll tactic is fairly insignificant compared to the ramifications of the changed accounting rule 157. 

This rule allows banks to legally overvalue underperforming assets. In other words, a house with a $500,000 mortgage, currently worth $300,000, could be valued at what the banks estimate it could sell the house for in a healthy market, ten years from today.

The balance sheets of hundreds of banks in the U.S. could be filled with $300,000 properties valued at close to $500,000. If you think that can’t happen, you may find the following numbers and statements taken from the FDIC’s website of interest:

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. This is just one of dozens of examples. Keep in mind that the combined assets of the four biggest banks are roughly about $7.5 trillion. Assuming those banks overvalue their assets by just 25%, a $1.8 trillion problem is yet waiting to the hit the fan.

Knowledge is Dangerous

After the recent decline that shaved as much as 17% off the S&P, investors have become a bit more skittish about owning stocks. Image what will happen when the public gets wind of massive amounts of non-performing assets hidden on bank’s balance sheets.

The 2008 decline was likened to the perfect storm as a variety of factors fell in place at the same time to create a major decline. The same thing might be happening right now.

On April 16, the ETF Profit Strategy Newsletter noted that “The pieces are in place for a major decline. We are simply waiting for the proverbial first domino to fall over and set off a chain reaction.”

There sure was a chain reaction. The initial decline was followed by the flash crash which was followed by even more selling. The 22 trading days following the April 26 highs have erased eight months worth of gains.

Bear markets are the best auditors. Falling prices reveal the ugly truth of such practices as the BofA story above. A couple of weeks ago, you also saw many more articles warning of a double dip recession than at any other time over the past six months.

This becomes a self-fulfilling prophecy and by extension a downward spiral. In between, there are sharp rallies that keep investors engaged and hopeful.

The savvy investors, however, are aware that the stock market has been moving from lower highs to lower lows, the classic pattern of a bear market.

Each issue of the ETF Profit Strategy Newsletter and semi-weekly updates includes detailed short, mid, and long-term forecasts along with an out of the box analysis of what’s really going on.