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(Adds share performance, comments throughout)
By Guillermo Parra-Bernal and Aluísio Alves
SAO PAULO, Aug 4 (Reuters) - A bigger-than-expected jump in loan defaults cast a shadow over strong second-quarter profit at Brazil's Itaú Unibanco Holding SA, another signal of the rapidly deteriorating outlook for banks in the nation's slumping economy.
For the first time in 11 quarters, default ratios at São Paulo-based Itaú increased on a quarter-on-quarter basis, offsetting the benefits of rising borrowing costs and strong fee income that helped drive profit to an all-time high.
Itaú's 90-day default ratio rose to 3.3 percent, the highest in a year and above the poll's 3.1 percent estimate. Itaú expects a further increase in delinquencies through the end of the year, Marcelo Kopel, head of investor relations, said on a call to discuss second-quarter earnings.
Shares of Itaú fell nearly 2 percent even though its net income of 6.134 billion reais ($1.78 billion) before special items beat the average estimate of 5.744 billion reais in a Reuters poll of 10 analysts. Return on equity hit 24.8 percent last quarter, above the poll's 23.3 percent estimate and the highest in almost five years.
"Looking at the results, it's hard to believe that Brazil is in a recession," said Deutsche Bank Securities analyst Tito Labarta. "But asset quality showed further deterioration signs and loans fell, which may trigger skepticism."
As unemployment climbs and economic activity falters in Brazil, investors are scanning banks' quarterly results to gauge whether profit trends look sustainable for an industry that last year posted its strongest performance in four years. The bank kept its outlook for this year unaltered.
Kopel said it was becoming increasingly difficult for Itaú to maintain profitability as economic activity plummets. Chief Executive Officer Roberto Setubal's steps to rein in costs and market-related risks will continue to bolster return on equity and efficiency metrics, Kopel said.
Itaú sold 1.1 billion reais in overdue, fully provisioned loans, which helped mitigate the increase in the default ratio, Kopel said. Excluding the sale, Itaú's loan book contracted 2 percent on a quarterly basis, underscoring the weak demand for credit in Latin America's largest economy.
Loan-loss provisions, or money that banks set aside from retained earnings to protect their balance sheets from the impact of rising defaults, fell 1.5 percent on a quarterly basis. On a 12-month accumulated basis, provisions reached 18.2 billion reais, slightly above Itaú's target of 15 billion reais to 18 billion reais.
$1 = 3.4451 Brazilian reais Reporting by Guillermo Parra-Bernal and Aluísio Alves; Editing by Lisa Von Ahn