* Markets hammer euro, Italian stocks, bonds
* Germany cagey on emergency euro group summit
* Ministers no longer explicitly rule out selective default
* EU to agree “shortly” on cheaper loans, longer terms
* Debt buy-back, bond swap under consideration
(Recasts with markets, IIF, German caution on summit)
By Julien Toyer and Luke Baker
BRUSSELS, July 12 (Reuters) - Financial markets hammered the euro and European assets on Tuesday after euro zone finance ministers opened the door to a possible Greek default and failed to prevent contagion spreading to Italy and Spain.
The euro fell for a third straight day and diplomats said European Council president Herman Van Rompuy was trying to convene an emergency summit on Friday to deal with the latest dangerous lurch in the euro zone’s debt crisis.
“It is essential that euro area member states and the IMF act in the coming days to avoid market developments spinning out of control and risk contagion acceleration,” the Institute of International Finance (IIF), a major banking lobby, warned ministers in a report.
However, EU paymaster Germany, which insists there is no need to rush new aid for Greece, appeared to be resisting efforts to force an early decision. A German government source said there were “no concrete plans” for a special summit.
Greek Finance Minister Evangelos Venizelos said his country needed more rescue loans by Sept. 15, adding that the markets were using Greece as an excuse to attack the euro and would never be satisfied, whatever reforms Athens implemented.
His German counterpart, Wolfgang Schaeuble, said a second Greek bailout could wait until September, and the new head of the International Monetary Fund, Christine Lagarde, said the global lender was not yet ready to talk about a new package.
The 17 euro zone ministers effectively accepted that involving private bondholders in future funding for Greece meant a selective debt default was likely, despite the European Central Bank’s vehement opposition to such a move.
“We have managed to break the knot, a very difficult knot,” Dutch Finance Minister Jan Kees de Jager told reporters. Asked about whether a selective default was now likely, he replied: “It is not excluded any more.”
Participants said a buy-back of Greek debt on the secondary market and a German proposal for a bond swap for longer maturities were under consideration after a complex French plan to roll over bonds made no headway.
Both would likely be regarded by ratings agencies as a default, or at best a selective default, which although it would not necessarily cover all Greek debt and could be lifted quickly, would have major repercussions for financial markets.
The increased likelihood of some form of default, and the lukewarm response from the IMF, sent European bank stocks and debt markets into a spin and propelled the euro sharply lower against the dollar although markets settled later.
Ten-year bond yields in Italy, the euro zone’s third-largest economy, shot above six percent for the first time since 1997 but then subsided to around 5.7 percent, still at a level which bankers say will put heavy pressure on finances.
Borrowing costs at an Italian 12-month bill sale surged to their highest since the 2008 financial crisis, putting a Thursday bond auction firmly in focus.
The chief executive of Unicredit, Italy’s biggest bank by assets, said his institution was being hit by speculative short-selling that bore no relation to the country’s economic fundamentals nor to the health of its banks.
In a sign of the seriousness of the situation, Italy’s centre-left opposition said it would rally behind the government’s 40-billion-euro austerity package, ensuring swift passage through parliament by Friday.
Prime Minister Silvio Berlusconi, whose feuding with Finance Minister Giulio Tremonti has heightened market alarm, sought to calm fears that Italy could be swept into a full-scale financial crisis, calling for national unity and an accelerated financial correction.
While political leaders sought to calm contagion fears, economists said the euro zone debt crisis, which began in Greece in late 2009, had turned far more serious.
Willem Buiter, chief economist at Citi and a former UK central banker, said there was a clear spread beyond Greece, Ireland and Portugal, the three nations bailed out so far.
“We’re talking a game changer here, a systemic crisis,” he said. “This is existential for the euro area and the EU.”
While the finance ministers were not explicit about how they planned to tackle Greece’s debt, saying only that proposals would be discussed “shortly”, they acknowledged that the debt pile — which stands at around 160 percent of GDP — had to be reduced.
“We stress the need to make Greek debt more sustainable,” Jean-Claude Junker, the chairman of the Eurogroup of finance ministers, said after more than eight hours of talks on Monday.
Economists regarded Junker’s words and the comments from other finance ministers as a fundamental shift, although it remains unclear what specific steps will be taken.
“The euro area now seems to be moving more explicitly towards debt relief via EFSF-funded purchases of secondary market debt,” JPMorgan economist David Mackie wrote in a research note. He was referring to the euro zone’s 440 billion euro emergency loan fund, which as it stands would not have enough resources to bail out Italy.
“Greece will need debt relief at some point, but it is not clear it is much of a help now. More likely the shift towards debt relief is intended as an attempt to limit contagion.”
Despite reiterating the need to have the private sector involved in a second package for Greece, how to do it remains unresolved. The ministers gave no indication that they had broken a stalemate over how to make banks, insurers and other funds share the cost of additional funding for Athens.
Germany, the Netherlands, Finland and others want the private sector to provide at least 30 billion euros in a new package for Greece that could total 110 billion euros.
Ministers tasked a working group to propose ways to finance a new multi-year programme for Greece, reduce the cost of servicing its 340 billion euro debt — nearly 160 percent of annual output — and improving its sustainability.
In a withering open letter to Junker, Greek Prime Minister George Papandreou said European partners had acted too slowly to stem the crisis while creating a “cacophony” that had ultimately put domestic politics before the common currency. (Additional reporting by John O’Donnell, Leigh Thomas, Dan Flynn and Julie Toyer in Brussels, Silvia Westall in Vienna, Stephen Brown in Berlin, Lesley Wroughton in Washington and Milan/Rome bureaus, editing by Mike Peacock and Paul Taylor)