EURO ZONE PLEDGES BAILOUT FUND / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

ECONOMY

MAY 8, 2010.

Euro Zone Pledges Bailout Fund

Bloc's Leaders Approve Greek Aid, Plan Stabilization Actions Amid Currency's 'Most Serious Crisis'.

By CHARLES FORELLE And STEPHEN FIDLER

BRUSSELS— Leaders of the 16 euro-zone nations agreed to assemble a fresh pot of money that could be used to rescue its troubled members, as a crisis spurred by Greece's fiscal woes spiraled well beyond its epicenter.

Meeting here past midnight Friday, EU leaders sealed their €110 billion ($145 billion) bailout of Greece, allowing money to be released in the next few days, and quickly turned their attention to the crisis's contagion into countries such as Portugal and into the European banking system.

European nations scrambled to build a bailout fund big enough to satisfy markets and contain a post-Greece crisis engulfing the entire eurozone.

The leaders agreed to create a "stabilization mechanism" over the weekend that would be in place before markets reopen Monday morning. There were few details on the mechanism, though French President Nicolas Sarkozy said the bloc's crisis response would "include all the institutions of Europe." He said the euro was facing "its most serious crisis since its creation."

One possibility for part of the stabilization mechanism is direct borrowing by the European Commission, the EU's executive arm, which would be guaranteed by European nations. A similar structure was used in earlier bailouts of non-euro-zone countries such as Hungary. A person close to the discussions described it as "not huge."

The euro-zone leaders also agreed on a host of other, longer-term measures, including a pledge to accelerate budget cuts across the bloc and to craft more effective sanctions for those who violate its debt and deficit limits—as Greece and others have done for years.

Europe was eager to demonstrate its capacity to move swiftly. Friday's meeting capped a tumultuous week in which financial markets panned Europe's muted response to the Greece situation—dumping both Greek bonds and the euro.

The leaders' expected ratification of the bailout it plans along with the International Monetary Fund was all but a formality. Finance ministers approved it Sunday, and the package on Friday cleared its highest hurdle: approval by the German parliament.

But the rescue has taken months to assemble and U.S. officials say that slow decision-making by European governments has already allowed the crisis to threaten Spain and Portugal and could lead it to spread.

In an ominous sign that the present contagion is moving faster than European governments are acting to stop it, investors punished the debt of Portugal, in a near-repeat of the credit squeeze that preceded the Greek bailout. Portugal ran a budget deficit of 9.4% of its gross domestic product last year and is struggling to tighten that gap.

Friday evening, the yield on a Portuguese two-year note stood at 8.78%—more than eight percentage points above what ultra-safe Germany pays to borrow. Just last week, that gap stood at three percentage points.

Concerns that European banks, major holders of euro-zone sovereign debt, are sitting on shaky assets, including billions of euros of government bonds, battered the interbank lending market Friday. Rates on short-term bank-to-bank lending surged, a small echo of the credit crunch of 2008.

Meantime, European leaders rowed against the market's tide, saying repeatedly that Portugal and Spain—the next weakest links--wouldn't need aid.

The difference between Portugal and Greece is "absolutely obvious," ECB President Jean-Claude Trichet said Thursday.

Investors haven't been reassured by the European response to the crisis. European officials began the year rejecting the notion that Greece would need financial help, saying a tough fiscal diet would be enough for the country to regain the capital market's confidence. A bailout emerged drip by drip over the course of several months.

That has dented confidence that Europe can handle a crisis broader than just Greece.

"Right now there is a very widespread skepticism about the European leadership," says Adolfo Laurenti, an economist at Mesirow Financial in Chicago. "Very early on there was very little understanding of the gravity of the situation of Greece."

EU leaders are loath to let Greece reduce its debt by default—a solution that would radically ease the country's fiscal pressures—in part because big European banks, primarily in Germany and France, are major holders of Greek debt. Big losses on that debt could trigger another banking crisis.

Another option is the ECB's direct purchases of sovereign debt. That so-called nuclear option wasn't even discussed at Thursday's monthly ECB meeting, Mr. Trichet said.

He didn't rule the option out, suggesting it is still a possibility especially if the actual dispersal of funds to Athens from euro-zone governments and the IMF fails to calm markets, ECB watchers say.

Friday, European Union President Herman Van Rompuy, asked about the nuclear option, stressed that all euro-zone institutions, including the ECB, "Agree to use the full range of means available." He didn't directly address purchases of government bonds, and the European Commission's chief stressed the ECB would make its own determination.

That doesn't mean the ECB is out of tools in the meantime, particularly when it comes to preventing sovereign default worries from trickling down to the banking sector.

If credit stops flowing between banks in private markets, as it did in 2008 after the Lehman crisis, the ECB could revert back to longer-term loans. At the height of the crisis it created six-month and one-year loan programs at the ECB's low policy rate, giving banks an unlimited source of cheap funds.

—Brian Blackstone contributed to this article.

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