Euro-area leaders redoubled efforts to end the 21-monthsovereign bond crisis as they erected a firewall around Spain andItaly and risked temporary default to lighten Greece's debtburden.

After eight hours of talks in Brussels, leaders announced 159billion euros ($229 billion) of new aid for Greece late yesterdayand cajoled bondholders into footing part of the bill. They alsoempowered their 440-billion euro rescue fund to buy debt acrossstressed euro nations after a market rout last week sparked concernthe crisis was spreading. The fund can also aid troubled banks andoffer credit-lines to repel speculators.

Greek, Spanish and Italian bonds rose after officials drewconcessions from Germany, the European Central Bank and investorsfor a twin-track strategy to support Greece and ensure its woesdon't spread. The summit is the latest in a running-battle toresolve the crisis amid calls this week for tougher action fromU.S. President Barack Obama and the International MonetaryFund.

“These measures are welcome because they create the bestpossible conditions for Greece and other peripheral countries toput their houses in order and hence limit the risk of contagion,”said Marco Valli, chief euro-area economist at UniCredit SpA inMilan. “Still, the market will continue to price some probabilitythat troubled countries will not be up to the challenge.”

Bond Rebound
The yield on Greece'stwo-year government note, which rose above 40 percent yesterday,has since plunged more than 1,300 basis points and was at 26.63percent at 12:13 p.m. in Brussels.

Italian and Spanish bonds climbed for a fourth day, with theyields on 10-year debt falling to 5.25 percent and 5.62 percent,respectively. Both exceeded 6 percent last week. The euro waslittle changed at $1.4410 after jumping as much as 1.6 percentyesterday.

The Greek financing package will consist of 109 billion eurosfrom the euro region and the IMF. Financial institutions willcontribute 50 billion euros after agreeing to a series of bondexchanges and buybacks that will also cut Greece's debt load, theleaders' communiqué said.

The European Commission plans to brief reporters on thepackage's technical details at 1 p.m. in Brussels.

European Monetary Fund
The leaders soughtto regain the initiative after market turmoil intensified amid aspat between ECB President Jean- Claude Trichet and GermanChancellor Angela Merkel over how to manage the crisis. The outlookwas worsened by signs that Greece was backsliding on axing itsbudget deficit as it struggles to cut a debt of 143 percent ofgross domestic product. A Bank of America Merrill Lynch poll thisweek showed investors trimming their European stock holdings to thelowest in more than a year.

French President Nicolas Sarkozy compared the transformation ofthe bailout fund to the creation of a “European Monetary Fund.”

“This meeting came at a difficult time,” Merkel told reporters.“I'm satisfied with the outcome because the euro countries showedtoday that we are up to the challenge, we can take action.”

The risk is that the drive will fall prey to the same internalEuropean Union wrangling that blunted previous drives to stop thecrisis. Bond purchases by the European Financial StabilityFacility, the region's rescue fund, will need the “mutualagreement” of member states and the facility may not be largeenough should markets turn on Italy and Spain at the same time.Leaders also refused to increase its size.

Crisis Management
“The EFSF has gone frombeing a single-barreled gun to a Gatling gun, but with the sameamount of ammo,” Willem Buiter, chief economist at Citigroup Inc.,told Maryam Nemazee on Bloomberg Television. “It needs to beincreased in size urgently.”

Sarkozy and other leaders also stressed that the Greek packagewon't be replicated for other countries.

European officials tried to draw a line under the crisis in May2010 when they set up the bailout fund and the ECB agreed to buygovernment bonds of debt-laden nations. That didn't stop Irelandand Portugal needing bailouts when splits over how to makeinvestors participate in financial rescues prompted a new wave ofbond market selling later in the year.

The pact still doesn't “make a significant dent” in Greece'sdebt and may disappoint investors by failing to boost the size ofthe rescue fund, said Jonathan Loynes, chief European economist atCapital Economics Ltd. in London. “We doubt that this package alonewill bring an end to recent contagion effects and prevent thebroader debt crisis from continuing to deepen over the comingmonths.”

German Coalition
For now, Merkel and herallies have succeeded in their drive to make investors co-financebailouts after voters balked at the cost of saving spendthriftnations.

“The summit resolutions fulfill the main elements of Germancoalition lawmakers' demands, above all the participation of theprivate sector in solving this crisis,” said Hans Michelbach, alawmaker in Merkel's ruling coalition, said in a telephoneinterview. “I see that a majority of coalition lawmakers willsupport Mrs. Merkel in parliament.”

Banks will reduce Greece's debt by 13.5 billion euros byexchanging bonds and “potentially much more” through a buybackprogram still to be outlined by governments, said the Institute ofInternational Finance, a Washington-based group representingbanks.

Investors will have the option to exchange existing Greek debtinto four instruments. Three will be fully collateralized byAAA-rated zero-coupon securities and have a 30-year maturity, andthe fourth will be for 15 years and partially collateralized byfunds held in an escrow account.

Sovereign Default
Crisis managers areaiming for a 90 percent participation rate from Greekbondholders.

“With this offer, the global investor community is steppingforward in recognition of the unique challenges facing Greece,”said IIF Managing Director Charles Dallara. The gathering was alsoattended by Deutsche Bank AG Chief Executive Officer JosefAckermann and BNP Paribas SA counterpart Baudouin Prot.

The ECB removed an obstacle to a new bailout after Trichetsoftened his opposition to a default which may be declared bycredit rating companies if the debt swap occurs. The ECB had untilnow said the euro region's first sovereign default could spark about of financial turmoil, clashing with Merkel's position that adefault could be inevitable.

Trichet Solace
Trichet signaledgovernments will guarantee any defaulted Greek debt offered ascollateral during money market operations. That may enable Greekbanks to keep tapping the ECB for emergency funds. Officials saidthe aim would be limit any credit event to a few days.

“The ECB pushed the argument as far as it could,” said LaurentBilke, an economist at Nomura International Plc in London who usedto work at the ECB. “It is Europe, everything is a compromise.”

Under the plan, Greece and fellow bailout recipients Portugaland Ireland will also have the interest rate on emergency loanspared. Maturities will be lengthened to as long as three decadeswith a 10-year grace period.

Trichet may gain solace from the bailout fund's wider remitwhich he repeatedly sought since the ECB suspended its own bondbuying program in April amid concern it was doing the work ofgovernments. Germany previously rejected broadening the EFSF, whosesize was beefed up to its original lending target as recently aslast month.

Passing Money
The facility will be able tobuy debt directly from investors so long as creditors agree and theECB declares “exceptional financial market circumstances.” EUPresident Herman Van Rompuy said the purchases could be used tostabilize markets as the ECB was doing or to help countries retiredebt at a discount.

The fund may also start passing money to countries to supportbanks a week after stress tests on 90 financial institutions put asmany as 24 under pressure to show they can raise capital.Precautionary credit lines would allow it to lend to nations beforemarkets freeze, mimicking a system introduced by the IMF for statesthat start losing investor faith even though they have relativelysound economies.

Governments will have to ratify the facility's new powers,posing a potential obstacle given domestic critics in Germany,Finland and the Netherlands.

Leaders dumped a suggestion to finance Greek aid through a taxon banks with a French official noting the threat had nudged banksinto agreeing to help in other ways. While they signaled no shifttoward issuing joint bonds, Germany's Deputy Foreign MinisterWerner Hoyer said in an interview on July 20 that it may eventuallyback the concept “if we further develop the European Union towardsa political union.”

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