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Gaming Grexit

Kevin Cook

Worried about the Greek election on Sunday? Join the club. British financial authorities, through the Bank of England, described their actions of earmarking $100 billion pounds ($155 billion) for potential banking-liquidity crises as a response to the 'dark cloud' over Europe.

Lots of Brits are hyper-critical of the eurozone crisis because it impacts the UK economy quite directly, even though they are grateful not to be a member of the monetary union. Ever watch Nigel Farage, leader of the UK Independence Party, go on an EU rant aimed directly at its leaders? It is must-see-youtube. I normally don't favor ad hominem arguments, but Mr. Farage is such an excellent orator and passionate, unrelenting debater that you can feel his conviction and his love of Europe.

No Way Out But Straight Down?

Whatever the simple mistakes in the creation and management of the single-currency regime in the past thirteen years, the problems and solutions just became drastically more complex in the past three.

While on the surface it appears that the Greek election is a simple choice between the leftist, anti-austerity, anti-bailout party SYRIZA and the moderate, pro-bailout New Democracy, the actual outcomes are a bit more complicated.

First of all, the chances that this election still does not result in a ruling coalition government are significant. I like the way Brian Sullivan of CNBC summed it up in a report published Thursday night...

'While the June 17 election is not directly billed as a referendum on Greece paying its debts and staying in the euro, it might as well be. If no party wins enough votes to form a coalition, as with the last vote, then the Greek situation may very well remain as it is now -- a jumbled mess of no real leadership, no real plan and perhaps no real way to stay a member of the euro zone economic family.'

Why no real way to stay a member of the EMU family? Because if Greece doesn't move faster on complying with the terms of their 2nd bailout, then the EU won't honor their side of the agreement. Even if Syriza's radical leader Tsipras simply comes to power and attempts to renegotiate, that's a better outcome than no government and a third election.

And the EU came out on Thursday saying they would consider tweaking some of the terms of the deal struck in February. While they won't alter the main targets, they said that there could be some flexibility in how to get there.

From the Reuters story Euro zone may tinker with Greek bailout terms after election...

'Under the memorandum of understanding detailing the terms of its 130 billion euro bailout, Greece must cut its debt to 116.5 percent of GDP, from 165 percent in 2011.

'This can only be achieved through savage public spending cuts, sweeping structural reforms and privatizations - all of which face substantial opposition in Greece.'

Limbo II

But renegotiating any of the terms and path to massive fiscal improvement that the bailout demands still requires a ruling coalition. And the Greek electoral process has some unique protocols that could give us another government in limbo.

For a new government to exist, it needs to have a simple majority of the 300 seats in the Greek Parliament. But the most recent polls, formal and otherwise, have been close enough to suggest that this could easily end in another stalemate -- especially since the socialist PASOK party help split the vote in early May.

While the majority of Greek citizens want to remain in the eurozone monetary union, they obviously have different ideas about who is best to lead them and keep them there. Many probably believe Tsipras that they can stay in the euro while he defies 'the troika' (EU Commission, ECB, and IMF) on the terms of painful austerity.

On top of this, the party which does win a majority of votes gets a bonus of 50 seats and the remaining 250 are distributed proportionally to the percentages obtained between those parties that received at least 3% of the vote. Therefore, the outcome is dependent on the party that comes in first, the number of parties that get into Parliament with at least 3% of the vote and the percentage that each party achieves.

This brings us to the second set of complexities: how an election victory could result in at least three different government coalition possibilities. I have read reports from several global investment banks on how they are 'gaming' the election results and the subsequent market impacts. Most of them turn into big decision trees and flow charts of complexity as they weigh all the variables and turns.

Game Theories

I will share one simplified version from Bank of America/Merrill Lynch and a depressing one from Goldman Sachs. But first, let me go back to Sullivan's piece because he has takes some of the potential results and impacts and makes them even simpler:

BEST FOR THE MARKETS: A New Democracy win with enough Pasok support to gain 151 seats in parliament.

SLIGHTLY BETTER / STAYS THE SAME: A win by New Democracy yet without the 151 votes combined with Pasok to form a ruling coalition. This outcome gets tricky because the winner would have to scramble to enlist the support of the other two more moderate parties, Democratic Left and Independent Greeks, to reach a deal that would effectively form a coalition.

And not all of these 'moderates' necessarily agree on the details of the bailout and its austerity requirements, so this still creates a lot of uncertainty about their ability to move forward. The good news is that they all want Greece to stay in the euro. The bad news is that they are politicians.

BAD FOR MARKETS: A big win by Syriza. This one doesn't need much explanation other than 'strap your helmet on' cause Mr. Tsipras is likely to drive his country off a cliff as he demands things from the troika that they are likely not going to give him.

And here is the BofA simplified scenario menu:

Base case (high probability): election result allows Greece to form a pro-EU government; limited European policy response.

Bull case (low probability): election result means Greece does not form a pro-EU government; substantial ECB & European policy response.

Bear case (low to medium probability): election result means Greece does not form a pro-EU government; limited ECB/ European policy response.

Liquidity Interrupted

Finally, here is my paraphrased version of the Goldman Sachs market forecast, mostly centered around continued stormy weather between Greece and the troika...

1. Hazy: Election results are inconclusive or result in an unstable coalition

Troika response: Interruption of funds for primary deficits and possibly structural funds as well

Impacts on Greece: 4% recession over next year. Stronger shock of up to 10% within 6 months.

Impacts on Europe and US: Somewhat neutral with initial shock possible. Bund and Treasury yields rise as flight to safety unwinds. Euro currency bottoms.

2. Victory for Syriza coalition rejecting austerity.

Troika response: Above plus debt service payments and requires FIREWALL for euro banks and sovereigns

Impacts on Greece: Banks come under increasing pressure and 'slow Grexit' becomes more probable

Impacts on Europe and US: Bigger shock to Eurozone economy (1% off GDP) and stocks, yields, euro fall but then bottom

3. Dark: Greece unilaterally repudiates liabilities

Troika response: Most liquidity to Greek banking system cut off

Impacts on Greece: 'Fast Grexit' scenario with inability to credibly establish new currency (it's not as if you can just say 'Hey, we're going back to the Drachma' at the flip of a printing press switch.

Impacts on Europe and US: Eurozone GDP drops 2%, euro falls to new crisis lows, new low yields for Treasuries and Bunds on panic flight to safety, stocks enter bear market.

You gotta love democracy. It's roots were born in Greece some 2,500 years ago. And it may just kill them as a nation, or at least as a going economic concern.

Just don't let it ruin your Father's Day. I have a feeling it's going to be a long hot summer with lots more Greek tragedy to come.

Kevin Cook is a Senior Stock Strategist with

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