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June and July may have been good months for the markets, but August definitely wasn’t. In fact, it is considered one of the worst situations for U.S. investment banks in years.

First it was mortgages, then it was areas like high yield and leveraged loans. Then came equities, which dried up investment banking activity as the market’s appetite for risk evaporated.

So while investors took a hit, brokers are also expected to demonstrate how much they suffered from the global liquidity crisis when their third quarter results are revealed. Lower M&A activity, as well as lower equity and debt issuance, are all expected to have a negative impact.

Bear Stearns’ (NYSE:BSC) high level of exposure to the mortgage market should make it the leader in earnings reduction this quarter, predicts Goldman Sachs analyst William Tanona. Meanwhile, his favourite large cap investment bank is Morgan Stanley (NYSE:MS), given its broad global exposure and product diversification.

For investors with a long-term view (beyond 12 months), brokers offer a very attractive balance of risk and reward, although business trends could see current challenges stretch into the fourth quarter, Mr. Tanona told clients in a note. But if investors are willing to stomach the volatility and possible downside, he thinks they will be handsomely rewarded given that the group is trading near trough valuations on a price to book basis.

For the three major U.S. brokers whose fiscal years end in November (Bears Stearns, Morgan Stanley and Lehman Brothers (LEH)), Mr. Tanona expects investors to look for commentary from management about the early part of the fourth quarter when they report next.

“If the firms cite improvements in activity levels across businesses, the brokers could rally meaningfully as the stocks are clearly baking in a rough 4Q2007, in our view,” he said. “Moreover, any help from the Federal Reserve on September 18 could also be a meaningful catalyst.”

Anything more than the expected 25 basis point reduction in the fed funds rate could provide a big boost for financial stocks.

BSC vs. MS vs. LEH 1-yr chart:

Source: U.S. Investment Banks: Brave Investors May Be Rewarded Handsomely