UPDATE 2-Norway's DNB Q1 profit surges on low lending losses
* Q1 operating profit hits $1.23 billion
* Loan losses seen below normal
* Maintains lending growth forecast
* Tier 1 capital ratio 11.9 pct vs 11.8 pct in Q4 (Adds analysts, share, outlook)
OSLO, May 8 (Reuters) - DNB, Norway's biggest bank, said on Thursday its loan losses virtually evaporated in the first quarter and would stay below normal all year, sending its shares higher and erasing some of its discount to Swedish peers.
State-controlled DNB said its operating profit rose 69 percent as loan losses dropped nearly 90 percent, costs declined and margins widened, improving its outlook with the Norwegian economy moving past its recent dip.
"These numbers were very strong. Estimates should move up after this and the stock should also move up," said Bengt Kirkoen, an analyst at Swedbank. "The drop in the volumes of problematic loans means losses ahead also will be lower than what is in the estimates."
At 0716 GMT, DNB shares rose 1.9 percent, outperforming a 0.5 percent rise in the European banking index.
DNB shares have fallen out of favour this year and underperformed the market over concerns that Norway's economy will be dragged down by slowing oil investment growth and lower house prices, adding to DNB's troubles from a soft shipping market, a key focus for its lending activities.
Indeed, based on its price-to-earnings ratio, DNB is the cheapest bank in the sector, Danske Bank said before the earnings report.
The stock fell 4.5 percent in the three months before Thursday's report, trailing a 6.9-percent rise in the Oslo benchmark, leaving the stock with a 35-percent discount to Swedish peers, based on its price to expected 2015 earnings ratio, brokerage Fondsfinans said.
Although net interest income trailed expectations and lending growth was just 2.2 percent, DNB raised investor confidence as it predicted accelerating growth after a big mortgage rate cut earlier this year.
"A cautious recovery is expected in both the Norwegian and the international economy during the remainder of 2014," DNB said. "Credit quality is expected to improve, while losses are expected to be below the normalised level in 2014."
It also predicted lending would grow by 3-4 percent this year, margins would hold after a big increase and costs would be flat through 2016.
Analysts said DNB would continue to erase its discounts once lending growth visibly picks up, the mortgage market gathers strength and DNB moves closer to building the required capital buffers.
The bank cut mortgage rates in the first quarter, a potential drag on its margins later this year, but the housing market has unexpectedly rebounded, improving the bank's outlook as it relies heavily on mortgage lending for growth.
DNB is one the best capitalised banks in Europe but still needs to save more cash to meet the government's strict rules. The bank earlier said it would pay out just 25 percent of its profits through 2016 before returning to a 50-percent payout.
Common equity Tier 1 capital ratio, the key measure watched by regulators, was 11.9 percent at the end of the quarter, up from 11.8 percent at the end of last year. It needs to reach 13.5-14 percent by 2016. (Editing by Matt Driskill/Mark Heinrich)