Savings and loan shares saw their role as the stock market's current safest bet tarnished Friday as investors dumped thrift stock en masse. Several big names were downgraded by brokerage analysts who cited concerns that the

Federal Reserve is done easing, although the scope of the selloff surprised even them.

"It was a little bit exaggerated,

and seemed almost like a flight to risk," said Mark Agah, analyst at Dain Rauscher Wessels, who downgraded

Golden West Financial

( GDW) and

Downey Financial

(DSL) - Get Report

to neutral from buy on Friday. "I didn't come out and say sell the things. I just said I don't see a lot of upside. And wham, they got crushed." Golden West gave up 10.4%, finishing at $54.75, and Downey lost 6.8% to end at $47.51. Both stocks are about 30% off their 52-week highs.

The Fed's rabid campaign to lower the price of money has been rocket fuel for a sector that derives its profit from the difference between what it pays on deposits and what it charges on loans. In an environment of monetary easing, the spread tends to widen, and more loans are made.

"We anticipate that, potentially in the fourth quarter and definitely in 2002, margins will come under pressure as we get to the end of the rate-cut cycle," said Agah, noting that after Friday's "bludgeoning," many thrift stocks are still trading at a relatively high average valuation of 10.5 or 11 times earnings. But the analyst said he'd recommend buying the stocks again if valuations drop to eight or nine times earnings.

Within the Russell 2000 index of small-cap stocks, financial services shares - a decent proxy for thrifts and mid-cap regional banks -- were up 13.5% in the second quarter, while their large-cap brethren in the Russell 1000 were up 8.2%. Before Friday, the S&P Bank Index was up 6.4% this year and 14% since last August, compared with declines in the

S&P 500 of 9.4% and 22.4%, respectively. The bank index gave back about two percentage points of that gain on Friday.

Most market participants expect the Fed to move again at its Oct. 2 meeting, although futures contracts showed slightly reduced chances following Friday's stock rally. Nevertheless, "tightening is hardly the name of the game here," said John Bollinger, head of Bollinger Capital Management, although he conceded the Fed could shift into neutral monetary policy soon. "I think the environment will remain comfortable for banks for some time. Whether they get the majority of the gains or not is a separate question."

Small Bets, Large Gains

The average small- and mid-cap bank managed year-over-year earnings growth of 10% in the second quarter, compared with 2% growth in large-cap banks, said Jason Goldberg, analyst at Lehman Brothers. Smaller banks for the most part have been insulated from trends that have hampered their larger counterparts, including shaky credit conditions and weakening commercial lending.

Pure-play mortgage lenders and regional banks have been posting record earnings. On Aug. 17,

Washington Mutual

(WM) - Get Report

, the largest savings and loan, reported a 63% increase in second-quarter earnings and forecast a strong second half. Its shares are up 10.3% this year.

Hibernia

( HIB), Louisiana's largest bank, is up 45%, while

Commerce Bancorp

(CBH) - Get Report

, which operates more than 150 branches around Philadelphia, is up 10.9%.

"Thrifts will probably perform OK for the remainder of this year, and the regional banks have had a tremendous run over the last several weeks because they've been safe," said Jim Bradshaw, analyst at D.A. Davidson. "But we need a spurt in economic activity for those stocks to go to another level."

Big Belts Tighten

Meanwhile, U.S. industry has been on an austerity drive that could lengthen unless the economy turns around and demand picks up. Despite seven rate cuts, average commercial and industrial loans declined 0.7% in the June quarter, according to the Fed. In contrast, real estate and consumer loan balances grew during the quarter.

In a second-quarter report, Credit Suisse First Boston said it saw no loan growth in its large-cap bank group, and that loan balances were off 0.4% year-over-year and down 1.2% on a quarterly basis. "Our banks' lack of loan growth was a reflection of the overall slowing in the economy, exacerbated by intentional balance sheet and business rationalization," CSFB wrote.

And, while not overwhelmingly bad, credit quality has suffered.

"The Fed easing has gone a long way to stem some of the deterioration," said Astrid Adolfson, vice president of MCM MoneyWatch. "But unfortunately credit deteriorates rapidly when new businesses don't have a good business plan and don't anticipate slowdowns."

"Larger banks make loans across the globe and participate in syndicated loans, and those are spots where we've seen problems," said Sean Ryan, managing director at Fulcrum Global Partners.

When the economy reaccelerates, large banks, with their diverse revenue streams, would probably see their earnings pick up. But few are willing to make that call now. "We're still on for a quarter or two of fairly weak comparisons" among big banks, said Steve Biggar, bank analyst at Standard & Poor's Equity Group. "I don't see any near-term resurgence in their businesses."