Europe is willing to let Greece default under a crisis response that would involve a bond buyback, a debt swap but no new tax on banks, EU sources said as euro zone leaders began a crucial emergency summit on Thursday.
A draft summit statement obtained by Reuters showed leaders were also considering a sweeping expansion of the role of their European Financial Stability Facility (EFSF) rescue fund to help states sooner, recapitalize banks and intervene in the bond market in a drive to halt contagion.
German Chancellor Angela Merkel and French President Nicolas Sarkozy crafted a common position on a second Greek bailout in late night talks in Berlin with European Central Bank (ECB) President Jean-Claude Trichet, who appears to have reversed the bank's stance.
Minds have been concentrated by the danger that Europe's debt crisis could engulf the much bigger economies of Spain and Italy. Greece, Portugal and Ireland have already succumbed.
"I expect we will be able to seal a new Greece program. This is an important signal. And with this program we want to grasp the problems by their root," Merkel told reporters on arrival in Brussels.
She offered no details, but Dutch Finance Minister Jan Kees de Jager said a short-term or selective default for Greece — long vehemently opposed by the ECB — was now a possibility.
"The demand to prevent a selective default has been removed," he told the Dutch parliament. The chairman of the 17-nation currency area's finance ministers, Jean-Claude Juncker, also told reporters: "You can never exclude such a possibility, but everything should be done to avoid it."
According to draft summit conclusions, the maturities on euro zone rescue loans to assisted countries would be extended to 15 years from 7.5, and the interest rate cut to around 3.5 percent from between 4.5 and 5.8 percent currently.
The EFSF would be able to lend to states on a precautionary basis, instead of waiting until they are shut out of market funding, and to recapitalize banks via loans to governments, even if they are not under an EU/International Monetary Fund assistance program.
The EFSF would also be allowed for the first time to intervene in secondary bond markets, depending on ECB input, the draft statement showed.
Germany blocked all these measures when the European Commission proposed them back in February, at a time when the crisis was less acute, EU sources said.
Euro zone sources said a buyback of discounted Greek bonds to help reduce Athens' crippling debt pile was seen as the most promising way of making private investors contribute to the cost of a second financial rescue.
German government and financial sources said the ECB would accept a selective default as part of a resolution of the country's debt woes through a bond buyback.
One source said the Franco-German agreement had Trichet's blessing. "You should assume that there will not be a banking tax," the source told Reuters.
The euro and European stocks, which had fallen on reports of a possible selective default, rallied against the dollar on news of the draft conclusions.
The risk premium investors demand to hold peripheral euro zone government bonds rather than benchmark German Bunds fell.
The 115 billion euro second Greek rescue package would involve both more official funding from the euro zone rescue fund and the IMF and a contribution by private sector bondholders, as well as Greek privatisation revenues.
Senior European bankers were present in the corridors of the Brussels summit but not at the table, officials said.
They included Baudouin Prot of BNP Paribas, the French bank with the biggest exposure to Greek debt, and Deutsche Bank chief executive Josef Ackermann, chairman of the International Institute of Finance, a banking lobby that has led talks among bankers.
Top Greek bankers were also there.
Leaders said their twin aims were to make Greece's debt more sustainable and prevent contagion from poisoning access to the bond market for other euro zone states.
The new bailout would supplement a 110 billion euro ($156 billion) rescue plan for Greece launched in May last year.
Worried about the impact on financial markets and wary of angering their own taxpayers, euro zone governments have struggled for weeks to agree on major aspects of the plan, especially a contribution by private sector investors.
The head of the European Commission, Jose Manuel Barroso, warned on Wednesday that the global economy would suffer if Europe could not summon the political will to act decisively.
Britain's finance minister George Osborne, in an interview with the Financial Times published on Thursday, said failure could produce an economic crisis as serious as the recession which followed the global credit crash of 2008.
New IMF Managing Director Christine Lagarde also attended the summit.
The global lender has urged euro zone leaders to put more money into their 440 billion euro European Financial Stability Facility, and let it buy government bonds of weak states on the secondary market.
The proposed expansion of the EFSF's role would have to be ratified by national parliaments, and could fall foul of critics in Germany, the Netherlands and Finland.
Thursday's summit is very unlikely to mark a complete resolution of the crisis, as Merkel herself acknowledged earlier this week.
A second bailout may simply keep Greece afloat for a number of months before a tougher decision has to be made on writing off more of its debt.
Many economists believe the only way out of the euro zone's debt crisis in the long run may be closer integration of national fiscal policies — for example, a joint euro zone guarantee for countries' bonds, or issuance of a joint euro zone bond to finance all countries.
Germany has firmly ruled out such steps, but Osborne said the second Greek bailout would only be a step towards a necessary fiscal union in the euro zone.
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