A Greek [Default/Bailout]: Flowcharting The Dominoes

It appears that in the 11th hour, Europe is still unable to decide just what the proper approach to rescuing Greece is. The Sunday Times has just released information that a plan to be published by Brussels on Tuesday, titled "Urgent measures to be taken by May 15, 2010" will demand dramatic Greek austerity measures, such as cutting "average nominal wages, including in central government, local governments, state agencies and other public institutions" and proposes new luxury goods and self-employed taxes. Yet the kicker is that "Richer eurozone countries such as Germany and France would be expected to bail out Greece in the worst-case scenario, to prevent a disastrous crash in the value of the single currency" - not very surprisingly, this is precisely the Plan B that Almunia yesterday swore up and down that the EU was not, repeat not, considering. Moral Hazard has indeed gone global. Yet even with this bureaucratic memorandum on the table, it seems certain that the EU will not actually act before Greek deterioration escalates out of control. Here are the near term catalysts that will likely make the cost of inactivity very high. Think full Dick Fuld stature when screaming upright.

But before presenting a timeline of near-term events, here is a simplified flow-chart of how bond, and CDS, investors should handicap Greece's near-term future, courtesy of Barclays.

As the chart highlights, the critical junction occurs once the market digests the forthcoming fiscal adjustment: should the market deem that insufficient, the immediate options are two: an EU bailout and an IMF bailout. We remind readers that the IMF has already pointed out that it would be willing to provide critical assistance to the Mediterranean country. In either case, Barclays expects that the "bailout" manifest itself via a bridge financing which would "buy time for another round of fiscal adjustment attempts." Logically, if the bridge ends up going nowhere, then the country will have to evaluate how to deal with a potential default scenario.

Of course, this flow chart will not occur in limbo and will be determined by a variety of internal and external stimuli.

Much has been made recently over Greece's €8 billion bond issuance. Yet in the near-term the country faces substantial bond maturities, which will have to be tackled ahead of their April and May refi dates. The chart below presents the key GGB maturities through the end of 2011.

If bond (and CDS) investors realize they have the potential to force issuance at even wider spreads than the recently auctioned €8Bn, look for upcoming GGB spreads to be materially wider than anything consider reasonable for a eurozone member.

As has been pointed out repeatedly in the past, Greece is the 13th largest GDP in Europe, implying even a default would likely not have dramatic consequences over the greater European economy.

The greatest procedural stumbling block is that the country has a euro-based currency, implying monetary policy in Greece can not be detached from what Brussels thinks is the proper approach for other European countries. This is precisely the reason why rumors of the drachma's reappearance have become so loud recently.

Yet while a Greek default in isolation would not be devastating, the proverbial snowball effect may lead to a much more dramatic climax. Where Europe is weakest is among some of the key Greek banking and trade partners, namely Bulgaria, Serbia, Macedonia. Furthermore, fiscal concerns will also implicate more "developed" countries such as Hungary and the Baltic states. Combine the two avenues, and you get a fully-blown continental crisis, which could reach to the very top in the GDP pyramid - Germany.

The conclusion is that of all countries, Bulgaria is by far the most exposed to a collapse in the Greek banking system and trade deterioration, with Serbia, Romania and Turkey following.

And while Almunia will likely have no problem in throwing Bulgaria and other poorer countries to the wolves, what is certainly keeping him up at night, aside from acid reflux as a result of just too many Davos functions, is the implication for other comparable fiscal debacles. This is where the rest of the PIIGS come into play.

The contagion threat from a "fiscal fear" standpoint is thus most acute at the more advanced recent EU inductees: Hungary, Latvia, Lithuania and Poland.

It is unfortunate that so far the EU has bet the house on a slowly-developing situation, in which cash and CDS traders exhibit a world of patience. Which they won't: as the last two weeks have shown, when Greek CDS exploded by over 100 bps, the EU's ability to control the situation is quickly evaporating. Furthermore, should CDS sellers commence to cover their long exposure in greater numbers, thereby minimizing further losses, the spreads for the abovementioned "contagion" countries have a likelihood of surging substantially more than to date. This will be magnified if existing GGB holders, who have so far withheld a desire to bail on their positions en masse, finally capitulate, as the yield impact will be much larger in the materially greater (in notional terms) cash market. The bottom line - the EU will soon have to move away from empty rhetoric to decisive action; should it wait any longer, the market, just like in the Lehman bankruptcy, may very well take any optionality away from the Brussels bureaucrats, and result in a fragmented, bankrupt, sick and contagious EU hinterland, whose disease will slowly but surely make its way to the heart of Europe. (Alternatively, CDS on Bulgaria, Hungary and the Baltics may still be relatively cheap, although Germany's may be by far the cheapest).