MILAN (Reuters) - Two U.S. private equity funds have quit talks to buy a mountain of bad loans from ailing Italian lender Monte dei Paschi di Siena BMPS.MI, sources said on Friday, dealing a blow to plans to secure a state bailout for the bank.

The entrance of Monte dei Paschi di Siena bank's headquarters in Siena, Italy, July 1, 2016. REUTERS/Stefano Rellandini/File Photo

Fortress FIG.N and Elliott were negotiating to buy some of the 26 billion euros ($29 billion) in bonds that Monte dei Paschi, Italy's fourth largest bank and the world's oldest, must sell to private investors as a condition of the bailout.

Fortress and Elliott had backed out of the talks in a dispute over sale terms, said three sources familiar with the matter. The loans have a face value of 26 billion euros but the bank, brought low by years of poor lending and mismanagement, is looking to sell them for around a fifth of that.

The funds’ withdrawal not only threatens the government’s efforts to save Monte dei Paschi, it could also complicate a separate and already-shaky plan by Rome to bail out two smaller troubled lenders, Banca Popolare di Vicenza and Veneto Banca.

Italy's banking shares fell on the news of the funds' withdrawal, with the sector index .FTIT8300 hitting a session low, down 1.7 percent. It closed down 0.5 percent.

If Fortress and Elliott do not come back to the negotiating table, Monte dei Paschi and the two regional banks have only one willing investor to turn to: Italian banking industry bailout fund Atlante, set up a year ago with Rome’s backing.

Atlante is considering whether to press on as sole buyer of Monte dei Paschi’s bad loans, the sources said. It has 1.7 billion euros in cash but has already committed to use 450 million euros to buy bad loans of the Veneto-based banks.

Atlante declined to comment.

Italy is scrambling to find private investors to help fund its 6.4 billion euros plan to bail out the two smaller regional lenders by the end of this month to avert them being wound down.

Rome is even considering suspending a bond payment due by Veneto Banca on June 21, in order to prevent the plan being held hostage by a potential legal dispute.

If Veneto Banca makes the payment, it could anger other bondholders who risk large losses under bailout rules. But if the bank does not pay back the bond, it could trigger a default.

This month, the European Commission gave Italy a preliminary green light to bail out Monte dei Paschi, which needs to fill a capital shortfall of 8.8 billion euros. But the bank first needs a binding commitment from private buyers to take the 26 billion euros in bad loans off its balance sheet, sources have said.

The European Central Bank “wants a binding commitment, they want visibility on the price in order to know what the loss will be for Monte dei Paschi,” one of the sources said.

Monte dei Paschi had previously said it was in exclusive talks with Atlante and other investors to reach an accord by June 28.

The bank will continue to negotiate with Atlante, having deemed the conditions set by the Elliott and Fortress as “unacceptable,” another source said.

($1 = 0.8941 euros)