UPDATE 1-Ireland's Permanent tsb says mortgage arrears have peaked
* Full-year underlying loss 977 mln euros, same as last year
* "Core bank" profitable this year, eyes 2017 group profit
* CEO says can work through loss-making tracker mortgages (Adds CEO quotes, details, analyst quote)
DUBLIN, March 26 (Reuters) - State-owned Irish bank Permanent tsb said its mortgage arrears had peaked and it was on track to return to profit by 2017, as it posted an annual loss of almost 1 billion euros ($1.4 billion), hit by impairments on bad loans.
Ireland's banks, the cause of its financial meltdown that forced it into an EU/IMF bailout, remain the main risk to the state and Permanent tsb (ptsb) is the weakest of the three domestic lenders, weighed down by its troubled mortgage book.
While the bank said on Wednesday it expects impairments to significantly reduce as mortgage arrears fall in a recovering economy, it added that mortgages which track the European Central Bank's (ECB) record low interest rate and make up two-thirds of its loan book would remain a drag on profitability.
Ireland had hoped to shift the so-called "tracker" mortgages from banks' balance sheets and while technical work was done throughout its three-year EU/IMF bailout, which was completed last year, no solution was reached.
"If someone gave us a few birthday presents, of course we'd take them. I don't live in dreamland," said ptsb chief executive Jeremy Masding, reiterating that an external solution did not appear to be on the way.
"We have always operated on the basis that we are the people to manage and fund the tracker book. We'll quantify the cost, we'll live with it and we will still make the bank profitable ... This group has a viable future," he added.
The impact of the tracker mortgages would wane as they are offset by profitable new mortgages and as ECB interest rates eventually rise, Masding said.
Ptsb's pre-exceptional annual loss of 977 million euros was the same as the year before after impairments for bad loans rose 4 percent following an assessment of bank balance sheets run by the Irish central bank last year ahead of European-wide tests.
Ptsb is seeking approval from Europe to split itself into three units and move bad assets - including some but not all of its tracker mortgages - off the balance sheet of a "core bank".
But it is still awaiting a decision on a restructuring plan submitted to the European Commission last year.
Masding said the group's "core bank" was profitable so far this year after seeing mortgage arrears peak in 2013 and staff costs fall by 15 percent, while the group as a whole remained on track to make a profit in 2017.
That compares with Bank of Ireland, which returned to an overall profit in the first two months of the year, and Allied Irish Banks, which also expects to make a profit later this year ahead of a potential reprivatisation in 2015.
Masding was confident the core bank would be an investable entity in the next few years and could be attractive to a large banking group.
He added he had not had any talks with Royal Bank of Scotland's (RBS) Ulster Bank about a potential merger.
RBS has commissioned investment bank Morgan Stanley to advise it on potential merger opportunities for its Irish unit, Ulster Bank said earlier this month.
Ahead of the European-wide bank tests, analysts said ptsb remained the most vulnerable Irish bank after its core tier one capital ratio fell to 13.1 following its balance sheet assessment and its net interest margin - measuring the profitability of its lending - rose marginally to 0.82 percent, far below its rivals.
"Given ptsb's weak earnings capacity, we still believe that the group faces significant challenges at the time of the forward looking stress tests," said Ciaran Callaghan, an analyst at Merrion Stockbrokers.
($1 = 0.7258 Euros) (Editing by Mark Potter)
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