Greek bonds and bank shares sank to new lows on Tuesday as a budget expert from Germany's ruling party pressured private banks to accept a discount on the Greek debt they own, spreading the pain of an international bailout.
Asset prices in Portugal, Spain and other weaker European economies also slid as investors speculated on the possibility of the region's rich governments failing to agree on the bailout in time to prevent Greece defaulting on some of its 300 billion euros of debt.
The markets smell blood, said Charles Diebel, head of European rates strategy at Nomura.
In Brussels, the European Commission said the idea of a Greek debt restructuring was not part of bailout talks underway in Athens between Greece, European authorities and the International Monetary Fund.
German Chancellor Angela Merkel's Christian Democrats (CDU) will raise the subject of forcing investors to take a discount on Greek debt with the IMF and the European Central Bank on Wednesday, the party's budget spokesman said.
Norbert Barthle said banks holding Greek government debt should be made to contribute to a rescue of Greece because they had profited from the crisis in recent months and had speculated against Greece in part.
That would mean whoever bought Greek bonds wouldn't get 100 percent of their value but say only 80, 90 or 70 percent -- it depends, Barthle said, adding it was too early to say how much of a discount on the debt should be sought.
French and German banks lent most to Greek borrowers and were owed $120 billion, according to Bank for International Settlements data released last week.
In Germany, public opinion strongly opposes using taxpayers' money to bail out Greece.
A European Commission spokesman said a restructuring was not on the agenda in the international bailout talks.
Let me be very clear - there is not going to be debt restructuring as part of the program. This has been one of the problems that have created uncertainty in the markets, said Marco Buti, director-general of the commission's economic and monetary affairs department.
Buti said the talks should be finished in early May. That could permit Greece to obtain as much as 45 billion euros in emergency loans from euro zone governments and the IMF this year, helping it over a funding hump on May 19, when Athens will need to refinance a maturing 8.5 billion euro bond.
Nevertheless, financial markets are worried by the political balancing act which Merkel is having to perform in pushing Germany toward participating in the bailout.
The backing of Germany, Europe's biggest economy, is vital for any rescue but Merkel's party is vulnerable to losing a regional election on May 9, depriving her coalition of its majority in the upper house of parliament.
Barthle's counterpart in the junior party of the coalition, the Free Democrats, said on Tuesday that a contribution to the rescue from Berlin was not yet guaranteed.
One may have to say 'no' if Greece does not meet conditions and the country just comes along to get money under more favorable terms from the euro zone than from banks, Juergen Koppelin said.
Merkel said on Monday that Germany was willing to help Greece if it showed a readiness to enact new savings to cut its debt and put its economy back on a sustainable path.
But European governments and the IMF cannot push Athens too hard to adopt tough austerity steps because that might undermine Greek public support for austerity, and by worsening Greece's recession, make its deficit-cutting targets impossible to hit.
The head of Greece's central bank said on Tuesday Greece should try to reduce its budget deficit by 5 percentage points of GDP or more this year, above current plans for a cut of four points.
The first opinion poll taken since Athens asked for emergency loans last week showed a majority of Greeks disapproved of the request.
Of 1,400 people surveyed, 60.9 percent said they opposed the government's decision, according to the poll by Greek Public Opinion, released on Tuesday by Mega TV.
Five-year Greek credit default swaps rose to a record high of 736.3 basis points on Tuesday, meaning it cost 736,300 euros to insure 10 million euros worth of debt against default.
Greek bank stocks plunged more than 7 percent while the spread of the 10-year Greek government bond yield over German Bunds, another measure of risk in holding Greek debt, ballooned to 689 basis points, the widest since early 1998.
Such a high spread means Greece would have to borrow at prohibitively high costs if it tried to raise money in the markets. Trade in Greek debt has in any case been drying up as jittery investors demand ultra-wide bid/offer spreads.
Doubt over European governments' ability to handle the Greek crisis hurt the bonds of other countries that might conceivably need bailouts if their debt problems worsen.
The 10-year Portuguese/German bond yield spread hit 258 bps on Tuesday, the highest level since Portugal joined the euro in 1999. Portuguese CDS hit a record high of 316.6 bps.
Many analysts believe Greece is likely to get enough international aid to see it through this year and perhaps several more years. But ultimately, the difficulty of reviving Greece's economy in the euro zone's monetary straightjacket might still force a default and even an exit from the zone.
A Reuters poll of about 50 economists last week found them estimating a 23 percent chance of a Greek default within five years.
(Additional reporting by Athens bureau, London markets team, and Dave Graham in Berlin; Writing by Tim Heritage and Andrew Torchia; Editing by John Stonestreet)