screengrab “Our situation has not improved.” See Also Citi Ups The Odds Of A Greek Exit From The Euro To 90% The Cracks In The German Economy Are Getting Bigger The Euro Area Downturn Is Getting Worse

Morgan Stanley‘s Global Cross-Asset Strategy Team led by Greg Peters is also worried about a Greek exit from the euro.  They’re also concerned about Spain, which is getting worse and is also much bigger than Greece.

From their latest note to clients:

Stress has returned to Europe, but the stakes are higher. Spain (let alone Italy) is not Greece: its economic size, the cost of a rescue, and the increased market skepticism about temporary fixes suggest that the policy response needs to include some of the political and institutional reforms that prior crises have not changed.

Conditions will likely worsen in the near term. Rating agencies have put investors on notice about further potential downgrades (not just to sovereigns, but also the European Financial Stability Facility, EFSF); Spain is struggling to maintain access to markets; and the price action is becoming disorderly. Our colleagues in Europe are not convinced that support from the EFSF (or the European Stability Mechanism, ESM) would be effective. Ending the cycle of crises requires concrete steps to fiscal union and the ECB to act as a sovereign backstop, as the Fed does for the US Treasury. These may come, but the crisis might have to intensify first. Aggressive ECB action, were it to come, could spark a material rally. If it does not come, then we may be nearing a messy Eurozone divorce scenario.

The EFSF and ESM are bailout funds from which debt-laden countries like Spain are expected to borrow cheaply.  However, should these funds get downgraded, the cost of those bailout funds would likely go up.

The CITI View

There is now a 90 percent chance of Greece leaving the euro zone over the next 12 to 18 months, according to Willem Buiter, chief economist at Citi.

Buiter, who coined the term ’Grexit’ back in May, has been assigning percentage chances of such an outcome over the last six months and now thinks it is all but certain Greece, the first euro zone member to be bailed out, will have to leave the single currency.

“Our base case (for the euro zone) is for prolonged economic weakness and financial market strains in periphery countries, spilling over into renewed recession for the euro area as a whole this year and the next,” Buiter wrote in a research note on Thursday.

“We now believe the probability that Greece will leave EMU in the next 12-18 months is about 90 percent, up from our previous 50-75 percent estimate, and believe the most likely date is in the next 2-3 quarters.” warned the former member of the Bank of England‘s monetary policy committee.

Greece leaving the euro will not be the only problem for euro zone policy makers to deal with over the coming months, according to Buiter.

“Even with the Spanish bank bailout, we continue to expect that both Spain and Italy are likely to enter some form of troika bailout for the sovereign by the end of 2012,” he wrote.

Stock markets’ focus has turned away from Greece after its second election of the year, in June, sawpro-bailout parties elected. Spain and Italy have moved closer to the spotlight – and Spanish bond yields have soared above the dangerous 7.5 percent level in recent weeks. Several Spanish regionshave already said they will need government financial aid.