You've probably seen the post-mortem in a bank examiner's report on Lehman Brothers' inflated numbers, and how its accountant - Ernst & Young - helped rig its balance sheet by shoving bad assets off the balance sheet and borrowing off of those assets in the repo market.

Fox Business warned you about Lehman's accounting fakery and bad numbers in five columns before this Wall Street firm collapsed ("The Fire-Engine Red Flags at Lehman Brothers," “Questions About Lehman Brothers Continue to Mount," "Breaking Down Lehman's Earnings," “Lehman's Losses,”and "Rescuing Lehman Brothers").

But Lehman's accounting fakery is just a piece of a much larger accounting trick, one that has exacerbated the ties that blind between company and auditor -- and it's a move that was perfectly legit under the rules, although Wall Street stretched it until it snapped.

Banks and Wall Street were aided and abetted by what are likely the most idiotic accounting rules known to man, rules manufactured by a quiescent Financial Accounting Standards Board [FASB] that let bank executives make up profits out of thin air.

The folie àdeux between Lehman and Ernst brings back memories of Arthur Andersen's off-balance sheet work at both Enron, as well as the firm's work on WorldCom, (Felix Salmon and zerohedge are the guys to read on Ernst's work on Lehman.)

But this little-understood accounting rule set alight the most massive off-balance sheet bubble of all, a rule that helped tear the stock market off its moorings.

Greed Talks in Dog Whistles

The rules acted like crack cocaine on Wall Street, and helped five Wall Street firms - Bear Stearns, Lehman Bros., Morgan Stanley, Goldman Sachs and Merrill Lynch - earn an estimated $312 billion based on fictitious profits during the bubble years.

A pundit once said that hatred talks in dog whistles. When it comes to accounting scams on Wall Street, greed talks in dog whistles. Because everyone was doing it.

Who Used the Rule?

Banks and investment firms including Citigroup, Bank of America and Merrill all used this "legit" rule.

Countrywide Financial made widespread use of this accounting chicanery (see below). So did Washington Mutual. So did IndyMac Bancorp. So did FirstPlus Financial Group, Mercury Finance Co. and New Century Financial Corp.

Brought to the cliff's edge, these banks were either bailed out, taken over or went through spectacular bankruptcies.

The rules essentially let banks frontload into their revenue the sale of mortgages or other loans that they packaged and sold off as securities, even though the payments on those underlying loans were coming in the door over the next seven, 10, 20, or 30 years. Estimating those revenues involved plenty of guesswork.

Many banks sold those loans to Enron-style off-balance sheet trusts, otherwise called “structured investment vehicles” (SIVs), again booking profits immediately (Citigroup invented the SIV in 1988).

So, presto-change-o, banks got to dump loans off their books, making their leverage ratios look a whole lot nicer, so in turn they could borrow more.

At the same time, the banks got to record immediate profits, even though those no-income, no-doc loans supporting those paper securities and paper gains were bellyflopping right and left.

The writedowns were then buried in obscure line items called “impairment charges,” and were then masked by new profits from issuing new loans or by refinancings.

Rulemakers Fight Back

The FASB has been fighting to restrict this and other types of accounting games, but the banks have been battling back with an army of lobbyists.

The FASB, which sets the rules for publicly traded companies, is still trying to hang tough and is trying to force all sorts of off-balance sheet borrowings back onto bank balance sheets.

But these "gain on sale" rules, along with the “fair value” or what are called "marked to market" rules, have either been watered down or have enough loopholes in them, escape hatches that were written into the rules by the accountants themselves, so that auditors like Ernst & Young can make a clean get away.

As the market turned down, banks got the FASB to back down on mark-to-market accounting, which had forced them to more immediately value these assets and take quarterly profit hits if those assets soured - even though they were booking immediate profits from this "gain on sale" rule on the way up.

Also, the FASB has clung fast to the Puritanism of their rulemaking by arguing a sale is a sale is a sale, so companies can immediately book the entire value of a sale of a loan turned into a bond, even though the cash from the underlying mortgage has yet to come in the door.

Old-Fashioned 'Channel Stuffing'

This sanctioned "gain on sale" accounting is really old-fashioned “channel stuffing.” 

The move lets companies pad their revenue and profit numbers by stuffing lots of goods and inventory (mortgages and subprime securities) into the system without actually getting the money in the door, and booking those channel-stuffed goods as actual sales in order to cook ever higher their earnings.

Sort of like what Sunbeam did with its barbecue grills in the '90s.

Intergalactic Bank Justice League

Cleaning up the accounting rules is an easier fix instead of a new, belabored, top-heavy “Systemic Risk Council” of the heads of federal financial regulatory agencies, as Sen. Chris Dodd (D-Conn) envisions in financial regulatory reform.

An intergalactic Marvel Justice League of bank regulators can do nothing in the face of chicanery allowed in the rules.

Planes on a Tarmac

What happened was, banks and investment firms like Citigroup and Merrill Lynch who couldn't sell these subprime bonds, or “collateralized debt obligations,” as well as other loan assets into these SIVs got caught out when the markets turned, stuck with this junk on their balance sheets like planes on a tarmac in a blizzard. 

Bank of America saw its fourth-quarter 2007 profits plunge 95% largely due to SIV investments. SunTrust Banks' earnings were nearly wiped out, a 98% drop in the same quarter, because of its SIVs.

Great Britain's Northern Rock ran into huge problems in 2007 stemming from SIVs, and was later nationalized by the British government in February 2008.

Even the mortgage lending arm of tax preparer H&R Block used the move. Block sold its loans to off-balance-sheet vehicles so it could book gains about a month earlier than it otherwise would. Weee!

The company had $75 million of these items on its books at the end of its fiscal 2003 year. All totally within the rules.

Leverage Culture

The rampant fakery helped fuel a leverage culture that got a lot of homes put in hock.

Banks, for instance, started advertising home equity loans as "equity access," or ways to "Live Richly" or as Fleet Bank once touted, "The smartest place to borrow? Your place."  

In fact, Washington Mutual and IndyMac got so excited by the gain on sale rules, they went so far as to count in profits futuristic gains even if they had only an “interest rate” commitment from a borrower, and not a final mortgage loan.

Talk about counting chickens before they hatch.

Closer Look at Wamu

Look at Wamu's profits in just one year during the runup to the bubble. Such gains more than tripled in 2001 at Wamu, to just shy of $1 billion, or 22% of its pretax earnings before extraordinary items, up from $262 million, or 9%, in 2000.

But in 2001, Washington Mutual took $1.7 billion in charges, $1.1 billion of it in the final, fourth quarter, to reflect bleaker prospects for the revenue stream of all those servicing rights.

It papered over the hit with a nearly identical $1.8 billion gain on securitizations and portfolio sales.  

Closer Look at Countrywide

The accounting fakery let Countrywide Financial Corp., the mortgage issuer now owned by Bank of America, triple its profit in 2003 to $2.4 billion on $8.5 billion in revenue.

At the height of the bubble, Countrywide booked $6.1 billion in gains from the sale of loans and securities.

But this wasn't cold, hard cash, no, this was potential future profits from servicing mortgage portfolios, meaning collecting monthly payments and late penalties.

“Counting future servicing revenue is perfectly legal in the mortgage industry; without it many lenders that are in an objective sense doing quite well would look as if they were headed for bankruptcy.”

Who said that? That was me! Back in 2003 while a senior editor at Forbes Magazine.