(Corrects paragraph 9 to show bad loan costs for six months, not nine)
* Top Japanese banks cut outlooks on bad loans, stock losses
* MUFG cuts full-year profit forecast 66 pct, Mizuho 55 pct
* Central bank says Japan economy in severe condition
By David Dolan
TOKYO, Oct 31 (Reuters) - Japan's two-largest banks, Mitsubishi UFJ Financial Group (8306.T) and Mizuho Financial Group (8411.T), cut their earnings outlooks by more than half on on Friday, hit by growing bad-loan costs and a plunging local stock market.
Once thought to be relatively insulated from the global credit crisis, Japanese lenders are now facing a sharp downturn in profits, hurt by a brittle domestic economy and overexposure to a stock market that has lost near half its value this year.
Resona Holdings (8308.T), Japan's fourth-largest bank, also cut its outlook on Friday, citing ballooning bad loan costs.
Underscoring the bleak outlook for the world's No.2 economy, the Bank of Japan cut interest rates for the first time in seven years on Friday.
Analysts believe that Mizuho and some of its smaller rivals may need to follow industry leader Mitsubishi UFJ and raise new capital to safeguard against the global financial meltdown.
Mitsubishi UFJ said this week it would raise up to $10.6 billion to replenish a capital base depleted by the stock market's fall and a $9 billion investment in Morgan Stanley (MS.N).
"Banks' unrealised losses on their shareholdings will continue to increase as the stock market falls. That will hit into their tier-one capital, which would force them to raise funds," said Reiko Toritani, senior director of financial institutions at credit agency Fitch Ratings.
Mitsubishi UFJ, which has spent about $14 billion this year on acquisitions at home and in the United States, cut its forecast by two-thirds. It now expects a group net profit of 220 billion yen ($2.23 billion) in the year to the end of March, compared to its previous forecast of 640 billion yen.
Bad loan costs rose to 245 billion yen in the six months to the end of September, while stock-related losses reached 75 billion yen.
Traditionally Japanese lenders hold large stakes in their corporate clients as a means to cement their business relationship.
The value of those stocks -- estimated at $250 billion at end-March -- has been shredded by the Nikkei share average's .N225 drop to a 26-year low this year.
Analysts have been particularly concerned about surging bankruptcies in Japan, which force lenders to increase their bad-loan costs, including provisions.
Mizuho, Japan's second-largest bank, said it now expects its group net profit to total 250 billion yen ($2.5 billion) in the year ending in March, down 55 percent from its previous forecast of 560 billion yen.
Japan's second-largest bank said it wrote down the value of its marketable securities by $1.4 billion in the six months to Sept. 30. Japanese shares lost a further 24 percent in the month of October.
Mizuho also said it was hit with 130 billion yen of bad-loan costs in the six months to end-September, due in part to the recent bankruptcy of U.S. investment bank Lehman Brothers.
Mizuho has been unable to break a dismal cold streak. The bank racked up 645 billion yen ($6.6 billion) in subprime-mortgage-related losses in the last fiscal year, having been one of the few Asian firms to take big bets on the risky U.S. credit products, whose collapse fueled a global credit crisis.
Resona, Japan's fourth-largest bank, cut its group net profit by 36 percent to 160 billion yen.
The bank expects bad loan costs to balloon to 152 billion yen in the year to end-March, more than double its initial forecast of 60 billion yen.
Shares of Mizuho finished down 5.2 percent after its announcement, while Mitsubishi UFJ lost 5.4 percent ahead of its announcement. Resona lost 0.4 percent. (Editing by Chris Gallagher & Kim Coghill)