The challenges facing the euro zone are immense and about to reach an "end game", according to one analyst who puts a 50 percent probability on everything turning out OK.
"The biggest challenge is: does Europe have the 'political will' to come up with a comprehensive solution? It clearly has the financial capacity and 'fire-power' to act," said John Wadle, the head of regional banks research at Mirae Asset Management on Wednesday in a research note sent to CNBC.
With Tim Geithner, the US Treasury Secretary, urging Europe to expand the size of the European Financial Stability Facility (EFSF) ahead of a meeting of euro zone finance ministers and the leaders of Germany, France and Greece set to hold a conference calllater on Wednesday, Wadle believes Europe’s banks need to come clean on losses on Greek debt.
"Greece’s current debt swap is not aggressive as the hair-cut is only 20 percent, while the debt markets already discount a 50 percent haircut," said Wadle, who believes this is central to the lack of trust in Europe’s banks.
"The issue is all banks need to be forced to mark-to-market this debt at 50 cents and not pretend it is worth more. If European banks can not be transparent about Greek debt, why trust them about anything," he wrote.
With the world worrying about how the debt crisis will play out, Wadle has assigned probabilities to three scenarios and believes there is a 50 percent chance of a happy ending, or as he puts it, a "good muddle through".
Wadle sees a 20 percent chance of Greece being allowed to default, forcing banks across Europe to take a 50-60 percent writedown on Greek debt.
The European Central Bank is then forced to be the buyer of last resort for Italyand Spain as governments guarantee deposits and debt of their national banking champions.
"European banks suffer dilution and debt losses, but we do not get a Lehman event for a European bank," said Wadle.
The second scenario Wadle assigns a 30 percent probability to is a bad muddle through which causes chaos for Europe’s banks.
Under this scenario, the EFSF would not be given a clear path to backstop Italian and Spanish debt, allowing the funding problems of Europe’s banks to worsen significantly over the next 3-4 months.
"We only get stop-gap measures from each EU government, mass labor strikes, and the political tension in Europe becomes so stressed that the euro drops to under 1.20. This is bad for the global economy and Italy/Spain debt zigzag wildly and (it) causes dollar funding for European banks to disappear,” said Wadle.
Stocks would fall by 20 percent, and Greece would default in December leading to the collapse of the Spanish and Italian debt markets, he said.
"Greece leaves the euro , followed by Portugal and Spain and Italy. The conversion of sovereign debt into local currency implies big haircuts of 30-50 percent. This causes chaos for European banks,” according to Wadle.
The third scenario in Wadle’s view has a 50 percent probability. It sees the EU muddle through the crisis in a good way.
This involves Greece getting another tranche of aid from the IMF/EU, buying a little time before Greece defaults in December.
“The EFSF is expanded to double the current proposed size, with the IMF providing one third of the funds. The ECB buys 1-1.5 trillion euros of Italy and Spain government bonds over the next year,” said Wadle.
European banks are forced to write down their Greek and Portuguese debt holdings to market prices and forced to raise capital, with the EFSF providing a backstop to any bank that cannot raise funds.
"To re-liquefy the ECB balance sheet in 1-2 years, Italy and Spain debt is converted into new debt with collateral/guarantees from the EU/IMF, but part of the VAT collected from Italy and Spain is directly transferred to the EU to service this debt,” said Wadle who says that with Europe divided there are risks to his analysis.
“Let’s hope Europe can pull itself back from the point of complete chaos,” he said.