WRAPUP 5-S&P threatens euro zone, EU chief urges bigger fund
* Ratings agency threatens to downgrade entire euro zone
* S&P also puts euro zone rescue fund AAA on negative watch
* EU summit chair proposes bigger fund with bank licence
* Sarkozy, Merkel seek treaty changes to restore confidence
* Geithner says encouraged by Europe developments, ECB central
By Luke Baker and David Lawder
BRUSSELS/BERLIN, Dec 6 (Reuters) - Standard & Poor's fired a second warning shot at the euro zone in 24 hours, threatening on Tuesday to cut the credit rating of its financial rescue fund as European leaders raced to find a political solution to their sovereign debt crisis.
German Chancellor Angela Merkel and French President Nicolas Sarkozy want to change EU rules to impose mandatory penalties on euro zone states that exceed deficit targets, aiming to restore market trust and prevent the crisis spiralling out of control.
Visiting U.S. Treasury Secretary Timothy Geithner said after talks in Berlin he was encouraged by recent moves towards fiscal union in Europe and stressed the central role of the European Central Bank (ECB) in tackling the crisis.
Citing "continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis", S&P put the ratings of 15 countries, including Germany and France, on review late on Monday for a downgrade by 1-2 notches.
The U.S.-based agency went a step further on Tuesday, placing the top-notch rating of the euro zone's 440 billion euro rescue fund, the European Financial Stability Facility (EFSF), on negative watch since it depends on the creditworthiness of the currency bloc's six AAA-rated sovereigns.
European Council President Herman Van Rompuy, who will chair a crucial summit of the 27-nation European Union this week aimed at turning the corner on the crisis, proposed giving a bigger permanent euro zone rescue mechanism the status of a bank that would allow it to access ECB funding.
Germany has so far opposed any such move, which it says would breach a treaty ban on the ECB financing governments.
Van Rompuy said tighter budget oversight sought by Paris and Berlin for the 17-nation euro area could be achieved quickly with only minor tweaks to the EU treaty that might not require full ratification procedures in many countries.
"To restore market confidence in the euro area, and to ensure the political sustainability of solidarity mechanisms, it is crucial to enhance the credibility of our budget rules (deficit and debt levels) and to ensure full compliance," he wrote in a report to EU leaders obtained by Reuters.
He also said the issuance of joint euro zone bonds should be a long-term objective, challenging another German red line in a text likely to be the object of heated negotiations.
S&P warned of slowing economic growth amid so much austerity, predicting a 40 percent chance of a fall in euro zone output.
A downgrade could automatically require some investment funds to sell bonds of affected states, making those countries' borrowing costs rise still further.
Merkel brushed off the threat, saying: "What a ratings agency does is its own responsibility." Her finance minister, Wolfgang Schaeuble, said the wake-up call was S&P's way of urging European leaders to act.
But Jean-Claude Juncker, chairman of euro zone finance ministers, said he was astonished by S&P's announcement, which he called "a wild exaggeration and also unfair" because it failed to take account of Italy's new austerity plan.
In Paris, Sarkozy's office said S&P had taken its decision last Tuesday, before both the Italian budget and the Franco-German plan for stricter budget rules.
Geithner met ECB President Mario Draghi in Frankfurt and Schaeuble in Berlin, starting a round of consultations with top European policymakers before the EU summit on Thursday and Friday, a sign that Washington shares the view that the event may be a decisive moment for the global economy.
He will also meet the leaders of France, Italy, Spain, and EU institutions to press for decisive action to halt the crisis.
That could provide the political cover that the ECB needs to buy more bonds of ailing countries as a stopgap, preventing countries from running out of money if they cannot sell bonds on the open market.
ECB chief Draghi has signalled that a euro zone "fiscal compact" could encourage the central bank to act more decisively on the crisis. It has been reluctant to buy up debt from distressed euro states more aggressively, arguing doing so would take pressure off governments to fix their finances.
Investors cheered a plan announced on Monday by new technocrat prime minister Mario Monti, slashing its borrowing costs. Yields on Italian 10-year bonds fell below 6 percent for the first time since Oct. 28.
Just last month, Italy - the euro zone's biggest debtor with 1.9 trillion euros of bonds outstanding - appeared headed for a crunch after the interest rate demanded by investors to lend to it soared above 7 percent, a rate at which other countries needed bailouts.
Were it not for his 30-billion-euro austerity plan, Monti declared, "Italy would have collapsed, Italy would go into a situation similar to that of Greece."
Goldman Sachs Asset Management Chairman Jim O'Neill told Reuters that Italian government debt yields now looked very attractive unless there was a "complete fiasco" at this week's EU summit. There would be no euro without Italy, he said.
Sarkozy and Merkel say they want treaty changes to be agreed in March and ratified after France wraps up presidential and legislative elections in June.
They won a boost on Tuesday when incoming Spanish prime minister Mariano Rajoy said he would support a new treaty. Although not yet in office, Rajoy is expected to meet Merkel and Sarkozy and outline his policies at a congress of European conservative leaders in Marseille on Thursday.
However, some other EU governments, notably Britain, Ireland and the Netherlands, are reluctant to amend the treaty, either due to eurosceptics at home or because they fear losing possible referendums on ratification.
If countries such as euro outsider Britain blocked a treaty change for all of the 27 EU members, the 17 states that use the common currency could proceed with an agreement on their own, Merkel and Sarkozy said.
S&P said it would conclude its review "as soon as possible" after the summit, making clear that it wanted to see political as well as financial solutions.
European stocks, bond futures and the euro recovered early losses after the warning, with analysts cautiously optimistic that the S&P move would spur European leaders into more decisive action.
Sarkozy and Merkel will send their own proposals to the EU's Van Rompuy on Wednesday, who would have preferred to avoid treaty change but is sounding out other governments on their receptiveness.
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