* European banks' capital, funding position improves
* Banks pay up to replace sold loan exposure
* Focus on maintaining interest income afer asset run-off
By Claire Ruckin
LONDON, Feb 22 European banks, including Spain's BBVA and Banco Santander, are buying back loans for top-rated European companies in the secondary loan market to replace exposure that was sold in a heavy bout of deleveraging in 2012.
The selective buying spree, which is being driven by banks' improving capital positions and reduced funding costs, could prove to be expensive, loan traders said.
Deleveraging banks bowed to political and regulatory pressure and sold discounted loans at around 90 percent of face value in late 2011 and 2012.
European banks, mainly Spanish, French and German lenders, could have to pay 500-800 basis points more to replace investment-grade loans for leading European borrowers after a rally in secondary loan prices.
Secondary loan prices have climbed in the last six months amid fresh demand as the eurozone crisis eased and sentiment improved.
European banks sold large loan portfolios last year to raise capital or to reduce the effects of spiralling funding costs. Some banks were losing money on loans with interest margins below their funding costs and opted to sell.
Santander sold a 2.5 billion euro ($3.31 billion) loan portfolio to Bank of America Merrill Lynch last October and BBVA sold around 1 billion euros of loans on an individual basis throughout 2012.
Spanish banks took losses to sell mixed portfolios that included toxic property loans which the banks needed to exit as well as performing investment-grade corporate loans to entice buyers.
"There was pressure on Spanish banks to sell loans. By selling portfolios they managed to get rid of bad property loans but unfortunately good corporate debt was also sold and now the banks want it back," a loan trader said.
BBVA and Santander were not immediately available for comment.
Major European banks now have money to spend and are looking to rebuild portfolios and boost interest income after a run-off in loan assets, as well as bolster relationships with key clients.
Spanish banks are selectively buying back some of the investment-grade loans in the secondary market that they sold last year while new primary loan volume remains low, bankers said.
These include large chunks of up to 200 million euros of European loans, one trader said, as banks also try to rebalance their portfolios and exposure to companies and industries.
Companies include Spain's largest utility Iberdrola , telecom company Telefonica and Portuguese utility Energias De Portugal (EDP), several traders said.
"Banks are no longer being paid a margin on the loans that they sold and are short of income. In an environment where loan margins have been compressed banks need to put a lot of assets back on their books," a loan banker said.
European banks are talking to loan traders and banks about replacing loan exposure.
Bank of America Merrill Lynch has been approached to see if it will sell back some of the portfolio that it bought, but is unlikely to agree with excess capital to invest, sources said.
Unsatisfied demand continues to push secondary loan prices higher.
"It isn't always easy to source the paper but you can always find a seller somewhere for the right price," the trader added.
Iberdrola's term loan is trading at 98 percent of face value, up from 95 in September 2012. The company's revolving credit is trading at 95, compared to 90 in September, according to Thomson Reuters LPC data.
EDP's revolving credit is quoted 99, compared to 92.5 in September, while Telefonica's term loan is bid at 97.2, compared to 94 in September, the data shows. ($1 = 0.7563 euros) (Reporting by Claire Ruckin, editing by Tessa Walsh)