Talks between Greece and its creditor banks aimed at avoiding a disorderly default broke down on Friday, with Greeks warning of disastrous results if a bond swap deal is not reached soon.

Athens needs an agreement, effectively seeing creditors voluntarily giving up a lot of their promised returns, to slash its debt to more sustainable levels and convince the European Union and International Monetary Fund to keep lending it cash.

In what some analysts said may be a high stakes poker game at the last stretch of intense negotiations to convince private bond holders to voluntarily take some losses to avoid the worst, both sides appeared to be digging in their heels.

A Greek default would be far worse for both Greece and the banks than reaching some form of deal.

Discussions with Greece and the official sector are paused for reflection, said the Institute of International Finance (IIF), which leads talks for private bond holders.

Unfortunately, despite the efforts of Greece's leadership, the proposal put forward ... has not produced a constructive consolidated response by all parties.

Greek debt swap negotiators said earlier they were less optimistic about reaching an agreement to avert a disorderly default, warning failure to reach a deal would be disastrous for Greece and Europe.

Yesterday we were cautious and confident. Today we are less optimistic, said a source close to the Greek task force team in charge of negotiations.

It is important to remind all parties that the consequences of failure would be catastrophic for Greece and the Greek people, Europe and Europeans, the source said on condition of anonymity.

Some analysts said the statements may reflect negotiating tactics by both sides in the final stretch of the race to clinch a deal.

I'm sure that's exactly what it is. You have a situation where there was an initial agreement to write off at one level, then it's a write-off at a higher level and I'm sure there's some people looking at it saying we can get a better deal, said Gary Jenkins, director of Swordfish Research.

When you're dealing with a sovereign, you don't have a huge amount of tricks up your sleeve, because if they choose not to pay you there's not an awful lot you can do, he added.

TALKS PAUSE FOR REFLECTION

The IIF's Charles Dallara held meetings in Athens on Thursday and Friday and Finance Minister Evangelos Venizelos said talks would most likely resume next Wednesday because there were issues that needed to be worked out but it was not immediately clear what the stumbling blocks were.

There is a meeting next week and we'll make every effort to succeed, the source close to the Greek side said.

Greece needs a deal to stay afloat when a 14.5 billion euro major bond comes due March 20 of and the bond swap paperwork alone will take at least six weeks.

EU, IMF and ECB inspectors, who arrive in Athens on Tuesday for talks on a new, 130-billion-euro rescue plan for Greece, also want to see an agreement on the debt swap before they agree on the bailout.

Any agreement with private bondholders on debt reduction should be in line with the terms decided by euro zone leaders on October 26, the EU Commission said on Friday.

Under the terms agreed in October, Greek privately held debt would be reduced by half, so that, together with structural reforms, the overall debt to GDP ratio of Greece would fall to a sustainable 120 pct in 2020 from 160 percent now.

A government spokesman said earlier that Greece had not decided yet on whether it will submit a law to force creditors into the bond swap, denying a Greek media report that it would do so by Monday.

Three senior euro zone sources told Reuters on Thursday that Athens was mulling such a bill, which would make a debt restructuring binding for all investors once a certain percentage agreed.

Without using so called collective action clauses, the participation rate in any debt swap deal could be smaller than needed because many hedge funds would profit more if Greece defaulted because they would get paid in full from insurance.

German Foreign Minister Guido Westerwelle will arrive in Athens on Sunday for a meeting with his Greek counterpart Stavros Dimas, as part of a flurry of diplomatic contacts.

Greece will test markets on January 17 with an auction 1.25 billion euros ($1.59 billion) of three-month T-bills to fund the rollover of a 2 billion-euro issue that matures on January 20. T-bills are Greece's only source of market financing.

(Additional reporting by George Georgiopoulos and Lefteris Papadimas, Douwe Miedema in London. Editing by Jeremy Gaunt.)

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