* Pension fund association says will support new bank rescue fund
* Monte dei Paschi working on bad loan sale, capital raising
* Bank likely to fare poorly in stress tests results Friday (Adds comment from source in 14th paragraph)
By Stefano Bernabei and Francesca Landini
ROME/MILAN, July 26 (Reuters) - Specialist Italian pension funds have agreed to a government call to invest in bad bank loans, as Rome works to build a safety-net around Italy’s No. 3 lender Monte dei Paschi ahead of European bank stress test.
The Tuscan bank, which has one of the heaviest bad loan burdens in Italy, is likely to be found short of capital under an adverse scenario when results of the latest Europe-wide banking check-up are released on Friday night.
In a bid to reassure the market, Italy is looking for ways to support its banks without breaking European Union state aid rules that would require investors to take a hit first
AdEPP, the association of sector-specific pension funds, said on Monday a decision had been taken to support a new bank fund called Atlante 2. Each fund will need to approve the investment.
AdEPP chairman told Reuters the government had asked its members to invest in Atlante, which is working with Monte dei Paschi on the sale of bad debts worth a net 10 billion euros ($11 billion).
A source familiar with the matter said Rome had asked for a 500 million euro investment.
Atlante, hastily set up in recent months to help Italy’s weakest banks, has used more than half of its initial 4.25 billion euro endowment to take over two failing regional banks.
The source said the new fund would only invest in bad loans and not bank equity.
Problem loans totalling 360 billion euros after a three-year recession have become the focus of investor concerns over Italian banks, weighing heavily on their shares.
Sources have said Italian state lender Cassa Depositi e Prestiti is also ready to provide up to 500 million euros to the new Atlante fund. A similar amount would come from SGA, another Treasury-controlled entity.
To comply with a request from European Central Bank supervisors to clean up its balance sheet, Monte dei Paschi last week submitted to the ECB a plan to sell its bad loans and is hoping for a green light by Friday.
Under the plan, Atlante would buy the bank’s loans to borrowers deemed insolvent in a complex scheme that aims to leverage fivefold the fund’s residual resources of 1.75 billion euros, sources have said.
Atlante is ready to buy the loans at a higher price than investors specialising in distressed assets would offer, but that would still be below the portfolio’s net book value, blowing a hole in the bank’s account and forcing it to raise capital.
A source close to the matter said Atlante would likely buy the loans at 30-32 percent of their nominal value, against a current valuation of 37 percent in the bank’s books.
Monte dei Paschi may struggle to raise cash at a time when sector profits are being squeezed by negative interest rates and poor asset quality. But EU state-aid rules have hampered Italy’s efforts to backstop Monte dei Paschi’s capital raising.
Another source with knowledge of talks between Italy and the European Commission on state support for weak Italian lenders said Rome now saw the possibility of state intervention as a last resort.
“It is only a contingency plan ... Rome is doing everything it can to avoid tapping public money,” the source said.
Monte dei Paschi shares, which have lost 76 percent this year, ended down 8.4 percent on Monday. ($1 = 0.9107 euros) (Editing by Susan Fenton, Alexander Smith and Mark Potter)