UPDATE 1-Reduce exposure to mid-size US banks - Morgan Stanley

April 7 (Reuters) - Morgan Stanley urged investors to reduce exposure to mid-sized U.S. banks ahead of the first-quarter earnings and lowered its earnings view on 26 banks in the group.

"Our gut feeling is that the group has rallied too far, too fast, particularly heading into earnings," Morgan Stanley analysts led by Ken Zerbe wrote in a note to clients.

It is still too early to get constructive on the banks given the uncertainty surrounding their fundamentals and the government bailout of the banking system, the analysts said.

In addition, the Federal Deposit Insurance Corp's special assessment fee (a one-time item) is yet another drag on the industry's profits in 2009, the analysts wrote.

"Modestly" raising their cumulative loss estimate for the group, Morgan Stanley analysts said commercial loan losses could be a major credit headwind for the banks in the upcoming quarters.

Morgan Stanley's first-quarter earnings view ranges from a loss of $1.86 per share to profit of 79 cents per share.

The brokerage also expects construction-related losses to be a lingering concern for many of the banks under its coverage, at least through the first half of 2009. (Reporting by Sweta Singh in Bangalore; Editing by Gopakumar Warrier)