By Thorsten Severin and Catherine Bremer
BERLIN/PARIS (Reuters) - German Chancellor Angela Merkel sought to bury once and for all the idea of common euro zone bonds on Tuesday, saying Europe would not share total debt liability "as long as I live", as the bloc's big four finance ministers met to narrow differences on how to solve a worsening debt crisis.
Two days before a crucial European Union summit, European Council President Herman Van Rompuy released a seven-page report on closer fiscal and banking union envisaging a euro zone treasury that would issue common debt in the medium term.
Merkel immediately stomped on the idea of mutualising debt - favored by France, Italy and Spain - at a meeting of lawmakers from her Free Democratic coalition partners in Berlin, according to people who attended the closed-door session.
"I don't see total debt liability as long as I live," she was quoted as saying, a day after branding the idea of euro bonds "economically wrong and counterproductive".
However Germany, the EU's biggest economy and paymaster, appeared ready to budge on using the euro zone's rescue funds more flexibly to help banks and reassure investors spooked by an increased risk of facing write-downs on government bonds.
The parties in Merkel's centre-right coalition proposed allowing a new permanent rescue fund, known as the European Stability Mechanism (ESM), to funnel aid directly to national bank rescue funds, according to a draft seen by Reuters.
That could spare governments like Spain's some of the political stigma of a bailout, although the loans would still be on the state's balance sheet, increasing its debt, and would still be subject to strict conditions.
More significantly, conservative floor leader Volker Kauder told another meeting of lawmakers that euro zone governments were discussing making it possible to remove preferred creditor status from the ESM rescue fund, participants said.
Neither Merkel nor Finance Minister Wolfgang Schaeuble, who insisted on that treaty clause to make private bondholders take first losses in any future debt restructuring by bailed-out states, spoke out in favor of such a move, the sources said.
The provision has scared investors off buying Spanish debt since Madrid was promised a bailout of up to 100 billion euros ($125 billion) for its debt-stricken banks, since they fear a possible "haircut", driving bond yields up to alarm levels.
Political tensions were already rising before word emerged of Merkel's dismissive comments.
Italian Prime Minister Mario Monti told parliament he would not just rubber stamp conclusions of the EU summit on Thursday and Friday and was ready to go on negotiating into Sunday evening if necessary to agree on measures to calm markets.
Cyprus, which on Monday became the fifth euro zone member to request a bailout, suffered a blow to its pride when the European Central Bank announced it would no longer accept the country's bonds as collateral - less than a week before Nicosia is due to assume the rotating EU presidency.
Euro zone finance ministers will hold a conference call on the Spanish and Cypriot aid requests on Wednesday, EU officials said.
Before that, finance ministers of the four biggest economies - Germany, France, Italy and Spain - were to discuss in Paris on Tuesday evening short-term crisis management and the proposals for closer long-term budgetary and banking integration.
Financial markets are on edge and international pressure for decisive action is rising but the summit, the 20th since the bloc's debt problems began in early 2010, is not expected to produce a lasting solution.
The finance ministers' session in Paris was called at such short notice - in an apparent rush to repair damage from a public rift between Merkel and leaders of the other three states when they met in Rome last Friday - that one finance minister's press staff only learned of the invitation on Tuesday morning.
The four finance chiefs were expected to seek more common ground before Merkel and French President Francois Hollande hold a pre-summit meeting on Wednesday.
HALF ITS ECONOMY
Cyprus, the 17-nation currency area's third smallest economy with just 1 million residents, added drama to a fraught week by applying for rescue loans on Monday.
Two euro zone sources said the East Mediterranean island, with an outsize financial sector heavily exposed to neighboring Greece, may need up to 10 billion euros in emergency financing, more than half its 17.3 billion euro annual output and equating to 10,000 euros per Cypriot.
While the sum is easily within the range of the European Financial Stability Facility (EFSF) bailout fund, it sets an awkward precedent and may lead to demands for private bondholders to take a write-down as they did in Greece.
Cyprus needs to plug a 1.8 billion euro capital shortfall in its second largest lender by June 30. Potential aid could be more comprehensive to cover fiscal requirements, Finance Minister Vassos Shiarly told Reuters.
Nicosia takes over the EU presidency for six months on July 1. But in Frankfurt, an ECB spokesman said that a downgrade of the Cyprus credit rating into speculative grade territory by all accepted rating agencies meant that Cypriot government securities no longer fulfilled the creditworthiness requirement.
This means banks cannot offer Cyprus government bonds in return for cash loans from the ECB.
Nicosia is believed to have applied to the EU for aid after exhausting attempts to secure loans from either China or Russia, a close ally, in an apparent effort to avoid the tough conditions and intrusive monitoring of an EU/IMF program.
"The exact number has not been decided yet. It was to be 6 billion for the state financing and 2 billion for the banks but that is optimistic - it is more likely to be seven and three - up to 10 billion euros in total," one euro zone official said.
On Monday, Spain formally requested up to 100 billion euros in rescue loans to recapitalize a banking sector that is weighed down by bad loans from a burst real estate bubble.
It is seeking to avoid the political humiliation and partial loss of sovereignty involved in a full state bailout program of the kind granted to Greece, Ireland and Portugal, even though the IMF and EU authorities will still have to monitor the aid.
Spanish and Italian bond yields rose again on Tuesday as skepticism set in before the EU summit. Spain had to pay the highest yields since last November to sell 3.08 billion euros in short-term debt as demand from its ailing banks dwindled.
Investors want to see bold moves to underpin the European currency union and halt the inexorable contagion from one debt-stricken country to another. But with 27 EU countries and 17 in the euro zone, quick steps are one thing Europe can't take.
The Brussels summit is expected to agree on a growth package pushed by France worth around 130 billion euros ($162 billion) in infrastructure project bonds, reallocated regional aid funds and European Investment Bank loans.
Leaders will also discuss proposals for a banking union but while they are likely to agree to give the ECB power to supervise big cross-border banks, Merkel is resisting any joint deposit guarantee or common bank resolution fund.
In Washington, U.S. Treasury Under Secretary Lael Brainard, who has been handling financial diplomacy with Europe, urged EU leaders to put "more flesh on the bones" of their plans for tackling the debt crisis at this week's summit.
(Additional reporting by Michele Kambas in Nicosia, Jan Strupczewski in Brussels, Catherine Hornby in Rome, Georgina Prodhan in Vienna, Lesley Wroughton and Chrystia Freedland in Washington; writing by Paul Taylor and David Stamp; Editing by Paul Taylor)