Not everyone is buying into Meredith Whitney's prediction that the municipal bond market will turn into a sequel to Apocalypse Now as 50 to 100 cities file for bankruptcy in 2011. But everyone does seem to agree that states and municipalities around the nation are confronting challenges they haven't experienced since the Great Depression.

Chris Ryon, managing director of Thornburg's municipal bond funds, recalls Whitney's appearance on 60 Minutes on December 19. "My mother-in-law was on the phone before the piece with Whitney was over," he remarks.

Between December 15 and early March, the municipal bond market entered a negative feedback loop that resulted in 8% of all the assets held in muni funds getting redeemed. "For Whitney's prediction to come true, we'd need to see $4.6 billion of municipal defaults a week," Ryon says.

That simply isn't happening, at least not yet. In 2010, there were 44 different municipal bond defaults, most of them involving non-investment-grade debt. These defaults were concentrated in so-called "dirt deals" for infrastructure like roads and sewers or nursing-home-related bonds.

Craig Alexander, chief economist at TD Bank, doesn't doubt that it's possible 100 different municipal entities could default. "But they won't be major cities," he told attendees at TD Ameritrade Institutional's annual conference in February. "The expectation of $100 billion in losses is off."

In fact, the biggest default in the last 12 months was a South Carolina toll road built on speculation that real estate surrounding the highway would enjoy a development boom that never materialized. Another near disaster in Harrisburg, Pa., was averted when the state bailed its capital city out.

Some have raised questions about Whitney's motivations. Few have read her research report since she is charging $100,000 for it. She was too busy to testify in front of Congress or provide them with a copy of it, Ryon notes.

He believes that after the sell-off in the market over the last three months, investors are getting paid to take prudent risks. This doesn't mean there won't be defaults on municipal projects in areas that witnessed big run-ups in real estate prices and subsequent busts in places like California's Inland Empire situated in Riverside, as well as parts of Florida.

Could there be a big one? Yes. Ryon says the most likely candidate could be Detroit. Others mention Stockton, Calif. The Motor City is much larger in size relative to Michigan than Harrisburg is to Pennsylvania and the state of Michigan is more financially strapped than the Quaker State, so a bailout might not be an option.

What about the longer term outlook for munis as pension costs start to explode later in this decade? Here again, Ryon is more sanguine. "In 2010, the Pew Center for the States suggested state and municipal pensions were 84% funded on average," he says. There were wide variances, of course, with New York's pension system being 107% funded and Illinois coming in at 54%. California stood at 87%.

Some actuarial experts believe an 80% level of funding is adequate because these are long-term liabilities, though others place it closer to 95%. Funding rates typically vary from year to year depending on a number of factors, including equity prices and contributions. The fact that some states are switching from defined-benefit pensions to defined-contribution plans and others are requiring higher employee contributions also is encouraging.

As events in Wisconsin revealed, workers in the private sector are becoming increasingly skeptical since public workers enjoy pensions that dwarf theirs. A recent study by Spectrem group found that while public employees represented only 15% of the nation's workforce, they held 37% of the nation's retirement assets.

State and municipal revenues are improving, albeit off a small base, Ryon says. In the third quarter of 2010, revenues were 4.9% higher than the corresponding period of 2009. That trend could be accelerating, since early reporting states in the fourth quarter of 2010 were 6.9% ahead of the final quarter of 2009.

Furthermore, state and municipal payrolls now have 400,000 fewer people than they did in mid-2008. "Both the revenue and expense sides are moving in the right direction," Ryon claims. "I don't want to sound Pollyannish. There are lots of issues out there and it takes longer than people expect to get everyone on the same page."

It may seem strange, but Ryon also finds the changing political climate comforting. New Jersey Gov. Chris Christie has given "a lot of other governors more political backbone" to address pension and benefit issues, and politicians in both parties are hitting "the difficult issues and taking on the unions."

Yet if one talks to the folks at Doubleline Capital LP, the fact that Whitney may have missed the mark with her predictions of total doom may not matter. Jeffrey Gundlach, the firm's CEO and CIO, has mentioned the possibility of soft or polite defaults where bondholders get paid eventually but some promises, particularly pensions, get modified.

University of Pennsylvania law professor David Skeel outlined one option earlier this year. If Congress amended Chapter 9 of the federal bankruptcy code to allow states and municipalities to modify their obligations, it could spark a wave of selling in the muni market.

Even if it never becomes law, mere talk of giving states and other entities the right to renegotiate existing contracts with the flick of a pen could spawn a panic. The negative feedback loop could get much worse. "If a few states start defaulting, all states will start to ask why shouldn't they?" Gundlach says.

Despite the hysteria Whitney created and the subsequent sell-off, Gundlach worries about the complacency among muni investors, whom he believes are largely in a state of denial. Accordingly, he thinks prices could decline 15% or more at some point this year.

Structural changes could bring the stresses and strains in the market to a head very soon. In April and May, the muni market is expected to see a big uptick in the supply of new issues. Two avenues of funding-the auction-rate securities market and Build America Bonds-no longer exist. So they'll have to sell billions of dollars worth of new bonds "to a traditional investor base that is increasingly skittish," said Greg Whitely, portfolio manager at Doubleline.

Ryon, Gundlach and Whitely may have slightly different takes on whether municipal bonds are fairly priced. But they agree that the psyche of the municipal bond investor makes them uniquely vulnerable to a panic.

Unlike other fixed-income vehicles, 70% of municipal bonds are owned by individuals, either directly or through mutual funds. Moreover, one-third of all closed-end funds are muni funds.

Many individuals, including millionaires and billionaires, invest their entire fixed-income allocation in munis. "They are not thinking about diversification; they are only focused on tax avoidance," one observer remarks. "They own munis for the wrong reasons and if there is a steady stream of negative headlines they will have trouble sleeping at night."

It's that kind of scenario that has Gundlach predicting that, if muni investors freak out, the panic could initially take the good bonds down with the bad. If bond prices drop 15% to 20%, closed-end funds might get completely slam-dunked and trade at big discounts to net asset values. That's why he's keeping his powder dry and waiting.

Were a raft of municipal bonds to actually default in the manner Whitney depicted, Gundlach acknowledges it would shock the entire financial system. "If the muni market blows up, it would affect everything," he says. "Defaults would clearly be a negative for consumers." But he suspects it will require much less to turn the muni market into a bargain basement.