Angela Merkel and Nicolas Sarkozy are running out of road.

Whether to allow Greece to default and how to manage thefallout, questions they have tried to avoid for more than a year,may finally require answers as European officials turn tofortifying banks and consider ways of easing Greece's debt load. Itcosts $6 million plus $100,000 a year to insure $10 million ofGreek securities for five years, with credit-insurance pricespointing to a 91 percent chance of default.

As the German chancellor and French president prepare to meet intwo days for their eighth bilateral summit in 20 months, Merkel hascited the need to prepare for the default that investors see as asure thing. Sarkozy, whose banks have the most to lose, isunwilling to gamble on letting Greece go.

“The whole German debate about a default of Greece is a Germandebate, not a European debate,” said Stefan Collignon, a formerGerman Finance Ministry official and political economist at theSant'Anna School of Advanced Studies in Pisa, Italy. “Thecommitment everywhere else, including in France, is very much toavoid that by all possible means.”

The heads of Europe's two biggest economies, along with theirfinance chiefs, meet in Berlin on Oct. 9 with the euro near anine-month low against the dollar. French 10-year bonds yield 78basis points more than their German equivalents, near the euro-erarecord set Aug. 8. Investors are demanding a premium of 21.4percentage points to hold Greek 10-year bonds over benchmark Germanbunds of similar maturity.

The leaders will discuss banks' finances in their Berlin talks,Sarkozy told reporters in Yerevan, Armenia, declining to commentfurther on the crisis.

Credit Ratings
The leaders' contrastingapproaches on Greece may reflect the relative vulnerability oftheir top credit ratings and economies. France's AAA rating and itsbanks are on the front line of potential damage, while Germanexposure to Greek debt is smaller.

Credit-default swaps on Germany have almost doubled this year toreach a high of 121 basis points Oct. 4. French CDS exceeded 200basis points last month. Higher prices indicate greater risk.

“Sarkozy is obviously the weaker partner,” Carsten Brzeski, aneconomist at ING Group in Brussels, said in a phone interview. Evenso, “Merkel needs Sarkozy's support on the debt restructuringissue, not necessarily that it's going to happen now, but that it'sgoing to happen sometime.”

Already the biggest contributor to bailouts for Greece, Irelandand Portugal, Merkel may not offer much in return when she hostsSarkozy at the Chancellery.

Last Resort
She's been stressing the limitsof joint action, saying Oct. 5 that Europe's rescue fund will onlybe used as a last resort to save banks and that investors may haveto take deeper losses in a Greek rescue. Germany is also resistingdiscussion of leveraging the 440 billion-euro ($586 billion) fundto boost its firepower.

European leaders are struggling to persuade investors they canstem the sovereign-debt woes as the crisis gnaws at the euro area'score, prompting speculation of another government rescue of DexiaSA, the municipal lender bailed out by France and Belgium in2008.

Underscoring the risks, Moody's Investors Service loweredItaly's credit rating by three steps on Oct. 4 and warned thateuro-area nations rated below the top Aaa level may have theirrankings cut.

Disagreements
Since the crisis broke out inGreece in late 2009, Merkel and Sarkozy have differed on key points— including the role of the International Monetary Fund in rescues,sanctions for countries that break deficit rules and how to makebanks take losses to help rescue Greece — before finding a wayforward.

Germany and France are at odds over whether the EuropeanFinancial Stability Facility rescue fund should have limits ongovernment bond purchases, Germany's Handelsblatt newspaperreported today, citing an unidentified European Union diplomat.

“Franco-German cooperation hasn't worked well in terms ofsolving the crisis,” Paul De Grauwe, an economics professor at theCatholic University of Leuven in Belgium, said in a phoneinterview. “The two have pursued different objectives.”

As German Finance Minister Wolfgang Schaeuble urges euro- areacounterparts to develop individual plans to protect their nations'banks, Merkel is laying out the scenario of Greece defaultingwithout leaving the currency union she has vowed to preserve.

'Barrier' Needed
“We have to be able to putup a barrier,” she said on Sept. 26. “I don't rule out at all thatat some point we will have the question of whether one can do aninsolvency of states just like with banks.”

She raised the specter of running out of time, patience andmoney on Oct. 5, prodding other EU governments to figure outwhether banks need capital boosts. “Time is short,” she said.

In contrast, Sarkozy has referred to Europe as a “family” thatmust stick together to support its weakest members. After hostingGreek Prime Minister George Papandreou at his Elysee Palace onSept. 30, Sarkozy rejected daring the markets with aninsolvency.

“The failure of Greece would be the failure of all of Europe,”Sarkozy told reporters. “Remember in 2008, when the U.S. let LehmanBrothers fail, the global financial system paid the price. For botheconomic reasons and moral reasons, we can't let Greece fail.”

Greek Holdings
Sarkozy, whose popularity isnear a record low as he decides whether to seek a second term nextyear, has reasons for concern. At the end of March, Frenchfinancial firms had $672 billion in public and private debt inGreece, Portugal, Ireland, Italy and Spain, according to Basel,Switzerland-based Bank for International Settlements. That's thebiggest exposure to the euro-area's troubled countries and almost athird more than German lenders.

Bank of France Governor Christian Noyer said last month thatFrench banks don't need recapitalization as Societe Generale SA,BNP Paribas SA and Credit Agricole SA, the country's largestlenders, have announced plans to reinforce their capital by cuttingassets.

Merkel, who faced down two junior parties in her government thatflirted with anti-bailout stances, won a victory last week when hercoalition's lawmakers passed an expansion of the EFSF that allowsit to buy sovereign bonds in the secondary market and recapitalizebanks.

Euro Stability
Merkel signaled that Germany'slargesse is now exhausted, saying Oct. 5 that the rescue fund's newpowers must only be used if the “stability of the euro as a whole”is at risk.

Merkel and Sarkozy issued coordinated statements on Sept. 14after a three-way phone call with Papandreou, saying they are“convinced” Greece will stay in the euro area.

In focusing on Greece, Europe's leaders are “asking the wrongquestion,” Irish Finance Minister Michael Noonan said yesterday ina speech in Ireland's upper house of parliament. Europe shouldrecapitalize banks to build a “financial firewall againstcontagion,” tackle Greek debt and then sort matters of governance,he said.

“The question is what should Europe do about the euro zone, andif you answer that question then Greece falls into context,” Noonansaid.

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