Updated with additional information on funds selling Bank of America.

NEW YORK ( TheStreet) -- Hedge funds pared their exposure to the financial sector in the second quarter as the sovereign debt crisis in Europe deepened and the U.S. economy showed signs of stalling.

An examination of the regulatory filings with the Securities and Exchange Commission shows that smart money dumped their exposure to large money-center banks including JPMorgan Chase ( JPM), Bank of America ( BAC) and Wells Fargo ( WFC).

Citigroup ( C) remained among the top holdings of hedge funds, according to filings data compiled by Bloomberg, and continued to see selective buying.

The big hedge fund names seemed divided in their outlook for Citigroup and Wells Fargo. David Tepper of Appaloosa Management , John Paulson of Paulson & Co and George Soros all cut back their exposure to Citigroup. Meanwhile Bill Ackman added to his stake in Citigroup, while Lee Ainslee's Maverick Capital took a fresh stake in the company.
John Paulson (Paulson & Co.)

While Soros and Maverick Capital sold Wells Fargo, Paulson upped his stake by 65%. The bank also continues to get strong support from billionaire investor Warren Buffett's Berkshire Hathaway ( BRK.A), who increased his holdings during the quarter.

However, most seemed to be in agreement that Bank of America was not worth the risk . David Tepper slashed his holding in the stock by 42%. John Paulson also gave the stock the ax.

Analysts continue to downgrade their estimates for the stock. The bank faces a particularly difficult battle with New York Attorney General Eric Schneiderman who is threatening to intervene in its $8.5 billion settlement with 22 institutional investors over mortgage-backed securities.

Even as hedge funds cut their overall exposure to banks, some financials continued to garner their interest. Significantly, Canadian banks seem to dominate the list, no doubt due to their sound balance sheets and healthy profitability ratios.

Credit card issuers, insurance companies and asset managers also made the list, suggesting that investors have perhaps given up on pure-play banks that are exposed to residential real estate.

Of course, data from these filings are as of June 30, which means their positions could have changed since then, especially as valuations of bank stocks have further dropped.

Here is a list of ten financial companies that hedge funds bought during the second quarter, according to Bloomberg data.

10. Morgan Stanley

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Eton Park, Highfields Capital, Pzena Investments, Viking Global and Lansdowne are some of the prominent hedge funds that own Morgan Stanley ( MS).

The investment bank saw considerable interest in the second quarter. Viking Global Investors took a fresh stake in the company, buying 6.1 million shares. Highfields Capital Management snapped up another 12 million shares.

Morgan Stanley has always traded at a discount to its rival Goldman Sachs ( GS), but after its strong performance in investment banking and trading in the second quarter, it has seen several analyst upgrades.

"We continue to believe there is scope for significant positive movement in MS's ROE return on equity over coming years," Barclays Capital analysts said in a note. "While those plans may take some time to fully achieve, we believe there may be some signposts along the way that can help shift the sentiment in MS shares to a more positive stance - namely a series of notable outperformances in the FICC business (equities is already showing promise) and consistently double-digit and upward trending wealth management pretax margins."

15 analysts rate the stock a buy or outperform. About 12 analysts maintain a hold rating, while two analysts rate the stock a sell or underperform.

9. American Capital

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American Capital ( ACAS), which has hedge fund titan John Paulson as its largest shareholder, continued to attract strong investor interest in the second quarter.

The business development company nearly filed for bankruptcy last June but managed to restructure its debt successfully.

In the second quarter, it paid down $100 million in securitization debt and improved its asset coverage ratio to 376%.The firm's assets under management totaled $51.9 billion at the end of the second quarter.

Pine River Capital, Arrow Street and Fortress were prominent buyers during the second quarter. Paulson's 12.67% stake in the company was unchanged.

FBR Capital recently upgraded the stock to outperform, citing potential buybacks that could boost the stock price.

Seven analysts rate the stock a buy or outperform. Four analysts have a hold rating on the stock.

8. Prudential Financial

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Prudential Financial ( PRU) saw hedge fund purchases worth $289 million during the second quarter.

Owl Creek Asset Management initiated a fresh position, buying 3.2 milliion shares in the life insurer. Highbridge, Fortress Investment Group ( FIG), GLG Capital and Steve Cohen's S.A.C. Capital were among the hedge funds that bought into the stock.

The Japanese earthquake and tsunami in March weighed on shares earlier in the year. The company, however, reported better-than-expected results in the second quarter. Net income came in at $831 million, or $1.68 per share, compared to $798 million, or $1.70 per share, in the year-ago period.

Excluding one-time acquisition costs and claims from the Japanese earthquake and tsunami, the company reported an adjusted income of $1.71 per share, beating estimates of $1.55 per share. Prudential in February acquired AIG's ( AIG) Japanese units- AIG Star Life Insurance and AIG Edison Life Insurance Company for $4.2 billion.

Barclays Capital has an overweight rating on Prudential, citing attractive valuations, impressive returns on equity, excess capital generation among favorable factors.

7. Bank of Nova Scotia

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Hedge funds snapped up about $321 million worth of Bank of Nova Scotia ( BNS) stock during the second quarter.

Canada's third largest bank stands out on metrics that few U.S. banks can boast of today. The bank reported a return on equity of 19.9% in the second quarter. It has a Tier1 Capital of 12%. Shares of the bank carry a strong dividend yield of about 3.9%.

Goodman and Company Investment Counsel, the investment management division of Dundee Wealth Management bought five million shares in the stock. Dundee Wealth is a wholly owned subsidiary of ScotiaBank.

Other prominent hedge funds that increased their exposure to the stock include Renaissance Technologies, DE Shaw, Citadel and Highbridge.

Eight out of 16 analysts rate the stock a "buy." Seven analysts rate it a "hold", while one analyst has a "underperform" rating on the stock.

6. American Express

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American Express ( AXP) found a big buyer in Atalanta Sosnoff, an investment firm that is 49% owned by Evercore Partners ( EVR). The firm bought 3.5 million shares of the credit card issuer during the second quarter.

First Eagle Investments, Adage Capital , Egerton, Bridgewater Associates were other notable buyers.

The pure play credit card lenders have been generating healthy profits . Credit card delinquencies are now at a 17-year low at 0.6% in the second quarter, according to credit reporting agency TransUnion.

Morgan Stanley's Betsy Graseck listed American Express as among the banks that will do well in a weak economy because it has the flexibility to manage net interest margins, keep costs down and return capital to shareholders in the form of dividends or share buybacks.

American Express is also among Goldman Sachs' top five bank picks.

17 out of 25 analysts rate the stock a "buy" or outperform, 6 rate it a "hold" and 2 rate the stock a "sell."

5. Discover Financial Services

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Shares of credit card issuer Discover Financial Services ( DFS) has gained 28% year-to-date outperforming universal banking stocks that are now mostly in the red for the year.

Discover recently announced a $1 billion share buyback program, offering further scope for returns to shareholders. For the second quarter ended May 31, Discover reported a net income of $593 million, or $1.09 a share, up from $185 million, or 34 cents a share, a year earlier. Discover's fiscal year ends in November.

Greenwich, Connecticut based AQR Capital led hedge fund purchases, buying 1.6 million shares in the stock. Notably, U.K.-based hedge fund Lansdowne completely exited its stake in Discover as did Glenview Capital and Level Global.

Michael Taiano at Sandler O' Neill has a buy rating on the stock with a target price of $28."Investors should view Discover as a cleaner story and an attractive investment given the scarcity value of possessing one of the largest credit card portfolios in the U.S. and a scalable payments network," the analyst said in a note .

10 out of 20 analysts rate the stock a buy or outperform, while the rest rate the stock a hold.

4. U.S. Bancorp

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U.S.Bancorp ( USB) is among the few large-cap U.S. banks that hedge funds bought during the second quarter.

The Minneapolis bank ranks high on profitability metrics, which makes it an analyst favorite. It also reported strong loan growth during the second quarter, which has eluded the other big banks.

First Eagle Investments, which operates both hedge funds and mutual funds, added 9.1 million shares of the bank to its portfolio during the second quarter. Viking Global Investors, Adage Capital were other big buyers.

19 of 34 analysts covering the stock rate it a buy or outperform,13 analysts rate it a hold, while two analysts have a sell or underperform call on the stock.

Deutsche bank analysts estimate that U.S. Bancorp along with JPMorgan Chase and Wells Fargo might be the least exposed to a decline in interest rates .

Oppenheimer analyst Chris Kotowski also recommends U.S. Bancorp for long-term investors as a relatively stronger bank that will "not be undone in a funding crisis and will not need dilutive recapitalizations."

3. Toronto- Dominion Bank

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Canada's Toronto-Dominion Bank ( TD) or TD Bank has been steadily building its presence in the U.S., moving in on opportunities vacated by the larger U.S. banks.

Bank of America ( BAC) recently sold its $8.5 billion Canadian credit card portfolio to TD. The acquisition would add 1.8 million accounts to TD's existing 4 million.

The bank has 1,200 branches in the U.S. throughout the NorthEast, Mid-Atlantic, the Carolinas and Florida.

The deal is expected to close in the next 18 months. TD expects the transaction to be accretive by 5 cents to adjusted earnings per share in fiscal 2012 and by 10 cents to adjusted earnings per share in fiscal 2013.

The bank also expects to issue up to 8 million equity shares for "prudent capital management" purposes, but the shares are not expected to be registered in the U.S. and may not be offered or sold in the U.S., the company said.

Goodman & Company Investment Counsel bought 6.5 million shares of the bank, representing the bulk of the hedge fund purchases. Renaissance Technologies and Citadel were other prominent hedge fund investors during the second quarter.

13 analysts rate the stock a "buy" or outperform. Two analysts have a "hold" rating on the stock, while one analyst has a "sell" rating.

2. Royal Bank of Canada

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Yet another Canadian bank that found favor in the second quarter was Royal Bank of Canada ( RY).

Goodman & Company bought 10.59 million shares in the company, while Renaissance Technologies, DE Shaw and Citadel were other hedge funds that added to their positions.

RBC exited the U.S. retail banking business in June, selling it to PNC Financial Services for $3.4 billion. The U.S. retail operation had suffered losses for several quarters as a result of the real estate crisis in the SouthEast.

Shares trade at a price-earnings multiple of 13.3, close to double the valuation ascribed to JPMorgan Chase ( JPM) which trades at just 7.7 times trailing earnings.

Five analysts rate the stock a "buy" or outperform. Ten analysts have a "hold" rating on the stock, while there is only one underperform rating on the stock.


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AIG ( AIG) floated a landmark stock offering of 300 million shares during the second quarter as part of its plan to help the government exit its massive stake in the insurance giant after a unprecedented bailout in 2008.

Hedge funds appear to have participated heavily in the re-IPO, pouring $1.3 billion into the stock. Larry Robbins' Glenview Capital bought 9.75 million shares of the stock during the quarter. Fortress Investment Group, D.E. Shaw and S.A. C. Capital Advisors were other prominent hedge funds that added AIG to their portfolios.

AIG shares are down a whopping 57.5% year-to-date. Shares currently trade below the re-IPO offer price of $29, much to the chagrin of investors. It will be interesting to see if hedge funds have cut their losses since then.

CEO Robert Benmosche has said that he believes the secondary offer was poorly handled by investment bankers who did not fully understand the company's trajectory.

Four analysts rate the stock a "buy" or outperform while nine analysts have a hold rating on the stock. There are no sell ratings.

Sandler O' Neill analysts have a buy rating on the stock but recently cut their price target to $37 a share from $40, citing lower 2012 earnings expectations and the fall of valuations of its property-casualty insurance peers. The brokerage cut 2011 operating EPS estimates to $3.61 from $4, which is still higher than the consensus estimate of $3.46. It also lowered the 2012 estimate by a penny to $3.60, compared to consensus of $3.23 per share.

--Written by Shanthi Bharatwaj in New York

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