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Euro zone finance ministers will discuss how to channel up to 100 billion euros in rescue loans to Spanish lenders weighed down by bad loans from a burst property bubble. Many in the markets see the package as a mere prelude to a full programme for the Spanish state.

"We have already started working on the design of the aid with the Commission, the European Central Bank and the International Monetary Fund," Spanish Economy Minister Luis de Guindos told reporters as he arrived for the ministerial talks in Luxembourg. "We will present the request in the next few days."

Spain's financial plight is centre stage a week before a European Union summit tackles long-term plans for closer fiscal and banking union in an effort to strengthen the euro's foundations, after bailouts for Greece, Ireland and Portugal failed to end a 2-1/2-year old debt crisis.

To pave the way, the leaders of Germany, Italy, France and Spain will meet in Rome on Friday.

Madrid sold 2.2 billion euros in medium-term bonds and attracted strong demand. But yields on 5-year paper rose to a 15-year high of 6.07 percent, a level regarded by analysts as unaffordable for any prolonged period.

The runaway Spanish yields contrasted with a French auction in which the yield on 5-year benchmark paper hit an all-time low of 1.43 percent.

"The first worry is can they (Spain) fund from the markets? They raised 2.2 billion versus a 2 billion target, so they can raise the money," said Achilleas Georgolopoulos, a strategist at Lloyds in London.

"Then the (question is), are the yields threatening for the medium term? And yes, clearly they are much higher than the previous auction ... But still they can continue for a few months to fund at these levels."

Two independent auditors are due to deliver a report to the Spanish government on the recapitalisation needs of the banking sector following last month's sudden nationalisation of Bankia, the fourth biggest lender.

De Guindos will present the findings to his euro zone colleagues in Luxembourg. Banking sources believe the report will say the lenders need to raise a further 60-70 billion euros.

"NO DEBT MUTUALISATION"

The finance ministers will discuss which of the euro zone's rescue funds - the temporary European Financial Stability Fund or the permanent European Stability Mechanism - will lend Spain the money. This matters to investors because ESM loans would be senior to other Spanish borrowing, meaning private bondholders would face first losses in any debt writedown.

The ministers are also expected to ponder the next steps with Greece, following the formation of a coalition of mainstream parties committed to the country's 130 billion euro EU/IMF bailout but determined to renegotiate some of the terms.

Athens will ask lenders for two more years to hit fiscal targets and an extension to unemployment benefits as it seeks to soften the punishing terms of the bailout saving the country from bankruptcy, a party official said.

Greek officials have said this would entail an extra 16-20 billion euros in foreign funding. It sets up a showdown with Greece's euro zone partners, in particular paymaster Germany, which have offered modifications but no radical re-write of the conditions attached to the lifeline agreed in March.

"We can always discuss conditions of the loan. But let us not forget one thing: This is not one-way development aid," Luxembourg Finance Minister Luc Frieden told Reuters Insider television.

RESCUE FUND TO THE RESCUE?

The German government and opposition reached a deal that will allow parliament to approve the euro zone's permanent bailout scheme next week, but Germany's top court may delay the rescue fund's start date scheduled for July 1, saying it needed time to study the treaty.

The ESM cannot go into effect without approval by Europe's biggest economy. Ratification also requires the signature of the president and a nod from the constitutional court in Karlsruhe.

The parliamentary floor leader of Merkel's conservatives appeared to dash French and southern European hopes of nudging Berlin towards common euro area debt issuance, saying there would be no mutualisation of debt in Europe.

The euro zone finance ministers may consider a suggestion by Italian Prime Minister Mario Monti, made on the sidelines of this week's G20 summit, to use the euro zone's rescue funds to buy the bonds of Spain and Italy in the secondary market to bring down their borrowing costs.

Monti hosts Spanish premier Mariano Rajoy, German Chancellor Angela Merkel and French President Francois Hollande in Rome on Friday and is also expected to raise the idea there.

Merkel has played down the proposal, which investors said might be counter-productive unless the ECB stepped in decisively in support.

Any cash injection would come with strings attached, equivalent to the sort of bailout programmes that Italy and Spain are trying to avoid because of the stigma attached.

Given the limited capacity of the temporary EFSF and planned permanent ESM rescue funds, with at most 500 billion euros available, a senior EU source said such intervention would make sense only if the ESM had a banking licence enabling it to borrow from the ECB. Germany has so far opposed that idea.

"Right now we have no requests to buy via the EFSF/ESM, Spanish or Italian bonds," Frieden said.

But he added: "We have funds available if necessary to help those countries in need ... We will do whatever is necessary to make sure that this zone, which is in trouble, will remain in the medium and long term a stable monetary union."

(Additional reporting by Leigh Thomas in Paris, Nigel Davies and Julien Toyer in Madrid, John O'Donnell in Brussels, Annika Breidthardt, Robin Emmott, Charlie Dunmore and Axel Threlfall in Luxembourg. Writing by Paul Taylor/Mike Peacock. Editing by David Stamp)