* Banco BPM has option to cut NPL portfolio to 7 bln euros

* Credito Fondiario to take 70 pct of debt recovery business

* Debt recovery platform valued at 143 mln euros (Adds details, advisers)

MILAN, Dec 10 (Reuters) - Banco BPM said on Monday it had agreed to sell up to 7.8 billion euros ($8.9 billion) in bad loans along with a stake in its debt recovery business to Credito Fondiario and U.S. fund Elliott, confirming what sources previously told Reuters.

The sale will allow Banco BPM to reduce its problem loan ratio to as low as 10.6 percent of total lending from 15.9 percent at the end of September, putting to rest concerns the bank may need to raise capital to clean up its balance sheet.

Credito Fondiario and Elliott were up against Italy's top bad loan specialist doBank, backed by U.S. private equity firm Fortress, and a third group comprising U.S. funds TPG, Christofferson, Robb & Company and Davidson Kempner.

Banco BPM, created last year from the merger of Banca Popolare di Milano and Banco Popolare, said it had an option to cut the size of the loan sale to 7 billion euros.

Italy's third-largest bank said the impact on its CET 1 capital ratios of the sale of the portfolio and its debt recovery business would be smaller than the boost from its consumer credit changes.

Banco BPM earlier this month struck a consumer credit agreement with Credit Agricole SA which helped to boost the Italian bank's capital, paving the way for this latest bad loan deal.

The bad loan recovery business, which will be 70 percent owned by Credito Fondiario, will manage the portfolio being sold but will also have a 10-year contract to manage 80 percent of new bad debt flows generated at the bank.

Banco BPM said the operation valued the whole of the loan recovery platform at 143 million euros.

Founded in 1898, Credito Fondiario has taken on a growing role in the Italian distressed debt market after London-based hedge fund Tages bought it from Morgan Stanley in 2013. Elliott became an investor in Credito Fondiario in 2016 and it recently increased its stake to 81.6 percent.

Earlier this year Credito Fondiario closed the acquisition of the debt collection business of Banca Carige and now manages more than 45 billion euros in bad loans in Italy.

PROBLEM LOANS

Problem loans are normally sold at a loss, which depletes a bank's capital reserves. A source involved in the bidding process told Reuters last month Banco BPM's bad loans were being valued at a fifth of their gross book value.

Banco BPM's latest efforts to clean up its balance sheet had run into difficulties due to a sharp rise in state borrowing costs under the country's eurosceptic government, which has made foreign investors nervous and hit the value of banks' sovereign bond holdings.