Despite the U.S. Federal Reserve Board’s term securities lending facilities program, analysts agree on two matters: another run on a U.S.-based investment bank could still happen; and, when parsing the major U.S. dealers, the critical concepts by which they’re being measured are liquidity and leverage.

So, if your clients are invested in or interested in investing in U.S. brokerage stocks, it’s certainly worth knowing the risks. And the collapse of another major U.S. investment bank ultimately concerns every financial institution globally — and markets generally — as these banks are counterparties to financial instruments everywhere.

“Globally, the financial system is interlinked through millions of contracts and whatnot. The collapse of [Bear Stearns & Co. Inc.] is a devastating problem,” says John Hadwen, a portfolio manager and a financial services analyst for Signature Advisors, a division of CI Investments Inc. in Toronto. “That’s why the Fed had to move in.”

The word “leverage” is used all over the place in the investment industry. The critical use in this case is the ratio of the bank’s debts relative to equity and other assets. On average, the top four investment banks — including Merrill Lynch & Co. Inc., Morgan Stanley & Co. Inc., Lehman Brothers Inc., and Goldman Sachs Group Inc. — are leveraged by as much as 26 to 30 times equity. For the past few years, it’s been standard operational practice for the dealers; but when the market for some of their assets freezes, they are deeply threatened.

The U.S. investment banks “typically do OK running with relatively high leverage because the assets they hold are so liquid,” Hadwen says. “It’s just that all of the sudden, a lot of assets that are typically liquid aren’t. In this environment, there’s a big question about what the assets are worth.”

The most illiquid assets are often tied to residential mortgages, but they also include other unsecurable portions of the credit market. On average, these sorts of assets make up about 30% of the U.S. investment banks’ holdings, according to Sanford C. Bernstein & Co. LLC, a New York-based research firm whose trading facilities also act as market-maker for Charles Schwab & Co. Inc., also based in New York.

Additionally, Peter Nerby, senior vice president of New York-based Moody’s Investors Service Inc., added in a conference call to Bear Stearns’ equity investors on the first trading day after the firm’s collapse that Bear Stearns could not support even its less risky assets. Lenders had lost confidence in the firm’s capital ratio, and prime brokerage clients had pulled cash from the company.

The analysis gets to one last critical phrase when looking at the brokers through a magnifying glass: net cash capital supply. The rating agencies and regulators monitor NCCS closely. The term speaks to a firm’s ability to finance its own balance sheet should all of its assets undergo a serious repricing. And could the firm meet short-term commitments using equity or its holdings in long-term debt as collateral?

As of Dec. 31, 2007, Merrill Lynch and Morgan Stanley had the largest cash capital surpluses, at 37% and 35%, respectively, while Goldman Sachs and Bear Stearns had the smallest, at 6% and 7%, respectively, according to calculations in the Bernstein report. Lehman’s cash capital surplus was at 10%.

In the past month, several U.S.-based brokers have posted earnings that have surprised markets to the positive side; but much of their assets remain illiquid, as reported in their statements.

Lehman reported that it held US$87.3 billion of total exposure to residential and commercial mortgage-backed securities, collateralized debt obligations and real estate. Of this total, approximately US$31.8 billion was in residential mortgages (including US$900 million of CDOs) and US$36.1 billion was in commercial mortgages. Among the residential mortgages, Lehman reported US$4 billion of subprime exposure and about US$13.5 billion of so-called “Alt-A” mortgages — a category of mortgages just below traditional bank lending risk levels.

Morgan Stanley reported that it owned US$46.8 billion in total exposure to the troubled income asset classes, but that it had reduced its exposure during the quarter — especially in commercial mortgage-backed securities and commercial loans. The Bernstein report calculates that Morgan Stanley’s gross leverage had dropped to 32.8 from more than 34 times by the end of 2007. That includes the firm’s much publicized US$5.5 billion in raised capital.

@page_break@Goldman Sachs reported that it had US$12 billion in prime mortgages and prime residential mortgage-backed securities on its balance sheet, as well as US$5 billion in Alt-A mortgages and US$2 billion in subprime mortgages and RMBS. It said it reduced its leverage loan exposure by US$20 billion in the quarter and that it had US$9 billion of unfunded leverage and loan commitments, as well as US$18 billion of funded loans, on its balance sheet.

Merrill Lynch 2008 first-quarter report comes out at the end of March, after IE’s press deadline. At the end of 2007, however, Moody’s tallied Merrill Lynch’s total illiquid risk assets at US$128 billion. That includes non-investment-grade loan commitments of US$26.5 billion and US$30.4 billion in CDOs.

The Bernstein report has a price target on each broker that implies, on average, a 44% price increase for the stocks. But the report stresses that it doesn’t recommend buying, despite what looks like value. It says that even with the Fed facilities in place, the brokers must maintain the confidence of creditors, counterparties and the fixed-income marketplace to continue their highly leveraged operations.

“With Bear Stearns having lost much of the fixed-income market’s confidence, the other large security firms will face sharply increasing funding pressure in the near term,” senior analyst Brad Hintz wrote in a note about Morgan Stanley’s first-quarter performance. “Investing in the brokers now is a bet on a recovery of confidence in credit markets that are experiencing the worst turmoil in several decades.”

In the absence of good news for the securities industry, a Bernstein report recently compared the U.S. life insurers favourably against the brokers. That’s a comparison that Hadwen points out as well. So, if you believe the market is poised for a rebound, the life insurance companies or asset managers are much safer, he says: “They have much less leverage, no liquidity issues, yet they’re also trading close to book value.” IE