(Reuters) - Morgan Stanley said it expects severe credit deterioration to pressure earnings of medium-sized U.S. banks and the banks would need to "meaningfully" increase reserves as the crisis worsens.

The investment bank began coverage of medium-sized banks with a "cautious" view.

Morgan Stanley said it sees credit weakness spreading into commercial credit later this year, which is not fully priced into the stocks.

The investment bank, which expects significant near-term credit deterioration in construction and home equity, recommended selling or shorting stocks with most exposure to these segments as those banks could take more losses and need to build more reserves than their less-exposed peers.

The magnitude of the reserve build will be a key differentiator between the better- and worse-performing stocks, it said.

The investment bank said its highest-conviction "underweight" stocks were Colonial BancGroup Inc CNB.N, First Horizon National Corp (FHN.N: Quote, Profile, Research) and South Financial Group (TSFG.O: Quote, Profile, Research), adding that it expects them miss estimates.

It sees considerably less risk in Hudson City Bancorp Inc (HCBK.O: Quote, Profile, Research), Peoples United Financial Inc (PBCT.O: Quote, Profile, Research) and SVB Financial Group (SIVB.O: Quote, Profile, Research), which are its highest-conviction "overweight" stocks.

It rated Cullen/Frost Bankers (CFR.N: Quote, Profile, Research), UnionBanCal UB.N and NewAlliance Bancshares (NAL.N: Quote, Profile, Research) as "overweight" and M&T Bank (MTB.N: Quote, Profile, Research), Synovus Financial (SNV.N: Quote, Profile, Research) and Huntington Bancshares (HBAN.O: Quote, Profile, Research) as "underweight."

Morgan Stanley said though the market has already priced the credit deterioration into most of the bank stocks, with the group down nearly 30 percent since the beginning of 2007, current valuations were not cheap.

(Reporting by Ratul Ray Chaudhuri in Bangalore; Editing by Amitha Rajan)