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Selloff Sinks Upbeat Bank Note

Investors ignore Morgan Stanley's buy-the-dip call.

An optimistic take on the large-cap banks was lost Friday in the latest financial sector selloff.

Morgan Stanley analyst Betsy Graseck says it is time to "bottom-fish" in the large-cap bank sector, because she believes the market has priced in much of the damage the banks will take on bad debt and related issues.

"We believe the group is already pricing in significant haircuts in the asset classes that are experiencing stress from credit contraction: subprime consumer, highly leveraged consumers and highly leveraged companies," writes Graseck in a note raising the group to attractive from in-line.

In addition, Graseck believes that the economy is not likely headed for a recession, as some observers fear. "While the market is already pricing an easier monetary policy in as soon as December, this could be a catalyst for the shares at a time when sentiment on the group is showing extreme pessimism," she writes.

But the positive spin on the banks was thrust into the background after Standard & Poor's cut its outlook on

Bear Stearns

(BSC)

to negative from stable.

Shares of the banks and large brokers have dropped sharply this summer as a result of the subprime mortgage meltdown and, more recently, the slowdown in the credit markets. Investors fear banks and brokers will be stuck holding billions of dollars in bad loans on their balance sheets.

Bear Stearns has been hammered because two of its hedge funds that had made big bets on securities tied to mortgages were found to be worthless last month. Earlier this week, the firm stopped redemptions in a third hedge fund tied to more mortgage securities.

Shares of the brokerage firms including Bear Stearns,

Lehman Bros.

(LEH)

,

Goldman Sachs

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and

Merrill Lynch

(MER)

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fell between 3% and 7%.

Large retail banks weren't faring much better on Friday.

Bank of America

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,

Citigroup

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and

JPMorgan Chase

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each dipped around 2%.

Graseck's top picks of the group include JPMorgan Chase, trust and processing behemoth

Bank of New York Mellon

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and

PNC Financial Services

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.

She pointed to expense management and share buybacks to support earnings growth in the second half of this year at large-cap banks, offsetting any further weakness in credit quality and margins, in a separate industry note.