* Credito Valtellinese had strong hedge fund interest
* Several Italian banks report reduction in bad loans
* Italy one of few "big opportunities" in Europe
LONDON, May 15 (Reuters) - Major hedge funds have picked Italian mid-tier banks as one of Europe's few remaining recovery plays, betting they will shed billions of euros in bad loans.
Europe's 2010-2012 debt crisis left Italy's banks with among the euro zone's biggest hangovers, some 285 billion euros ($338 billion) of soured debt on their balance sheets.
But when Credito Valtellinese sold new shares in a February rights issue for eight times its market value, they were lapped up by hedge funds in the United States and Britain.
Now the mid-sized Italian bank counts Algebris Chief Investment Officer Davide Serra, Toscafund Asset Management and a hedge fund run by Eurizon Capital SGR among its biggest investors, Thomson Reuters data shows.
So far the bet seems to be paying off as Italy's bank shares have risen 15 percent year-to-date against a fall of 1 percent for European banks, while Credito Valtellinese stock has risen 7.5 percent since the rights issue completion.
Although the price-to-book ratio of Italian banks has improved since Rome announced a state bailout fund in 2016, it trades around 8 percent below the European sector average.
Even the possible formation of a new government comprising two anti-establishment parties has not put off many of the funds contacted by Reuters, some of whom invested in Greek government bonds on a similar bet, who said the investment stacked up despite the vagaries of Italian politics.
Italy's bad loans are a legacy of the recession that followed the debt crisis and with small and medium-sized businesses heavily dependent on bank lending, the soured loans have long been a drag on the third biggest euro zone economy.
But pressure from regulators has begun to have an impact and the ratio of gross impaired loans to total loans has fallen to 14.5 percent from 17.3 percent a year ago, Bank of Italy data shows, the biggest improvement since the global crisis.
Even Italy's highest-profile problem lender, Banca Monte dei Paschi di Siena, has reported progress.
"It's the last financial sector in Europe that is very cheap and there is a roadmap to recovery in the next couple years," said Giuseppe di Mino of Amber Capital, citing Credito Valtellinese as an example of a compelling opportunity to gain exposure to the sector and its improving loan portfolios.
Nigel Gliksten, partner at Toscafund, told Reuters that a recovery story was stronger in Italy than Greece as its banks should also benefit from improving growth and the prospect of euro zone interest rate rises from 2019.
"We like this sector for the exposure to domestic economic recovery and for the exposure to interest rates," said Francesco De Astis, head of Italian equity at Eurizon Capital SGR, which bought into the Credito Valtellinese issue.
Italy's economy is seen expanding by 1.5 percent this year, the same as 2017, which was the fastest rate since 2010.
Caius Capital recently took a trading position in UniCredit and is pushing for it to convert a 2.98 billion euro ($3.57 billion) convertible bond into shares in order to raise both its core capital and its share price.
Funds see opportunities in bonds too, although Louis Gargour, chief investment officer of LNG Capital advises avoiding subordinated or "junior", bonds which are often written down in event of default or debt restructuring.
"The risk-reward in the subordinated part of the riskier Italian banks may be written down but the senior debt will perform," Gargour said.
But when Monte dei Paschi, which needed state help last year to avoid insolvency, sold 750 million euros of five-year junior bonds in January, almost a third went to hedge funds, according to data provided by one of the bankers who managed the sale.
Other funds took 52 percent, with the remainder divided among banks, insurers and other investors.
Banks have dealt with the bad loan problem in different ways, from UniCredit's 13 billion euro rights issue to Intesa Sanpaolo's recent sale of several billion euros of non-performing loans to Sweden's Intrum Justitia.
They have also packaged and securitised non-performing loans to sell them on, helped by Italian government guarantees on senior tranches of repackaged NPLs.
The biggest risk now, one hedge fund manager said, is that a new government scraps these as while Italy's Treasury is working to extend the scheme beyond September, a renewal must be approved by the next government.
"If the government doesn't pay for it, someone else will have to pay or the bank values will have to fall to reflect that," the fund manager, who declined to be named, said. ($1 = 0.8363 euros)
(Reporting by Abhinav Ramnarayan, Maiya Keidan and Alasdair Pal in London, additional reporting by Valentina Za in Milan and Tommy Wilkes in London; Graphics by Alasdair Pal; Editing by Sujata Rao and Alexander Smith)