Ratings agency Moody's gave a resounding thumbs-down on Friday to Europe's efforts to resolve a rolling debt crisis, slashing Ireland's credit rating by five notches despite an EU/IMF bailout.

The rare steep downgrade came in the middle of a European Union summit intended to restore market confidence by creating a permanent financial safety net for the euro zone from 2013 and vowing to do whatever it takes to preserve the single currency.

Moody's cut Ireland's rating to Baa1 with a negative outlook from Aa2 and warned further downgrades could follow if Dublin was unable to stabilize its debt situation, caused by a banking crash after a decade-long property bubble burst.

While a downgrade had been anticipated, the severity of the downgrade is surprising, Dublin-based Glas Securities said in a note.

News of the latest blow to confidence broke as the 27 leaders began a second day of talks on how to stop contagion spreading from Greece and Ireland to other high-deficit euro zone countries such as Portugal and Spain.

The recent events have demonstrated that financial distress in one member state can rapidly threaten macrofinancial stability of the EU as a whole through various contagion channels, a draft final summit statement seen by Reuters said.

This is particularly true for the euro area where the economies, and the financial sectors in particular, are closely intertwined.

At their first session on Thursday, leaders rejected calls for immediate practical steps such as increasing the size of a temporary bailout fund or allowing it to be used more flexibly to buy bonds or open credit lines before troubled countries are shut out of the credit markets.

German Chancellor Angela Merkel, who led opposition to those options, sought to reassure citizens and markets on Friday, declaring: We are doing everything to make the euro secure.

She said the euro zone would have to move beyond crisis management next year and build step-by-step a common economic policy.

The European Central Bank moved on Thursday to bolster its firepower to fight the debt crisis by announcing it would almost double its subscribed capital.

But analysts said this was chiefly to cover potential losses on euro zone sovereign bonds bought so far, not to step up such purchases to support governments in trouble.

ECB President Jean-Claude Trichet told reporters the central bank's governing council thought it was appropriate to make additional provisioning -- a veiled reference to potential losses on euro zone sovereign bonds it has bought.

IF INDISPENSABLE

At Germany's insistence, the 27 leaders said the long-term crisis-resolution mechanism, to be added to the EU's governing treaty, would only be activated if indispensable to safeguard the stability of the euro as a whole.

They also decided there was no need to increase the existing temporary rescue fund, which some analysts say could be insufficient if Spain and Portugal need EU/IMF bailouts after Greece and Ireland, nor did they discuss using it more flexibly.

The premium investors charge to hold Greek, Irish, Portuguese or Spanish bonds rather than benchmark 10-year German Bunds crept up further on Friday in thin pre-Christmas trading.

The decision not to enlarge or even discuss enlarging the existing fund could be taken by financial markets as a sign of division, potentially provoking more market uncertainty.

The decision taken was that there will be no enlargement or deepening of the funding means at the disposal of the EFSF, said Luxembourg's Prime Minister Jean-Claude Juncker, referring to the existing European Financial Stability Fund.

A French delegation source said the leaders also touched on Juncker's proposal for common euro zone bonds, strongly opposed by Merkel, but there was no consensus to take it forward.

The leaders -- holding a record seventh summit this year -- approved a two-sentence amendment to the EU treaty at Germany's behest to permit the creation of a European Stability Mechanism to handle financial crises from June 2013.

The ESM, to replace the temporary European Financial Stability Facility created in May, will be empowered to grant loans on strict conditions to member states in distress, with private sector bondholders sharing the cost of any writedowns.

The aim is for all 27 member states to ratify the change by end 2012. European Council President Herman Van Rompuy, chairing the summit, said no country would need to put it to a referendum, removing one potential risk. Decisions will be taken by unanimity, ensuring that EU paymaster Germany retains a veto.

The EU, together with the IMF, set up a 750 billion euro ($1 trillion) EFSF loan pool to help highly indebted euro zone states unable to finance themselves in volatile markets.

There has been a relative lull in financial market pressure in the past two weeks as investors and traders close their books ahead of the end of the year, but analysts expect turbulence to resume in 2011 as Spain and Portugal face refinancing crunches and the rating agencies clearly so no diminution of risk.

On Thursday, Moody's highlighted investor fears about the first country to receive an EU/IMF rescue by saying it was putting Greece under review for a downgrade, due to uncertainty over its ability to cut debt.

Earlier this week, Moody's put Spain's debt on review for a possible downgrade and Standard & Poor's said it may cut Belgium's debt rating next year.

Throughout 2010, EU leaders have struggled to show unity and clear communication in handling the crisis, alternating between rushing out half-formed or contradictory proposals and dithering on the right course of action while markets burned.

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