(Bloomberg) The U.S. government will face pressure to bail out struggling states in the next 12 months, said Meredith Whitney, the banking analyst who correctly predicted Citigroup Inc.'s dividend cut in 2008.
While saying a bailout might not be politically viable, Whitney joined investor Warren Buffett in raising alarm bells about the potential for widespread defaults in the $2.8 trillion municipal bond market. She said state and local issuers have taken on too much debt and that the gap between public spending and revenue is unsustainable.
"People will think the federal government will bail these states out," Whitney, 40, the founder of Meredith Whitney Advisory Group Inc., said in an interview on Bloomberg Television's "In the Loop." "It's going to be an incredibly divisive issue."
Whitney's comments coincide with her release of a report rating the financial health of the 15 largest U.S. states measured by gross domestic product, according to Fortune magazine. The report, which Whitney said took two years to complete and hasn't been released publicly, ranks California's finances the worst, with New Jersey, Illinois and Ohio tied for second-worst.
The longest recession since the Great Depression has left states facing budget gaps of $72 billion next fiscal year, according to a July report by the National Conference on State Legislatures. State pension funds face deficits of more than $1 trillion, according to the Pew Center on the States. The amount of municipal debt outstanding has increased about 90% in the last decade, according to Federal Reserve data.Buffett and Bailouts
In May, Buffett, whose Berkshire Hathaway Inc. owns and insures municipal debt, told shareholders at the company's annual meeting that the federal government would likely bail out a state that faced financial distress.
Municipal bond analysts including George Friedlander of Citigroup say those predicting widespread defaults are exaggerating the connection between budget pressure and failure to meet payments on general-obligation bonds.
"While states' financial conditions are undeniably stressed now and will reasonably remain stressed for the next decade or more, GO bondholders are generally well-cushioned versus other interested parties-taxpayers, service recipients, employees, vendors-who will feel pain more directly," said Municipal Market Advisors in a report today. The Concord, Massachusetts-based firm said it hasn't seen Whitney's report.Bondholder Claims
Whitney overlooks the claim bondholders have over pledged revenue and the willingness of municipalities to pay debt obligations to maintain access to the capital markets, Municipal Market Advisors said.
A study last year by Moody's Investors Service found 54 defaults in municipal bonds it rated from 1970 to 2009. Although gross domestic product declined 30% during the Depression, the cumulative default rate for municipal bonds was 2.7%, according to Citigroup.
Since December, the total net assets of municipal bond funds has increased 12.3% to $513.3 billion, according to the Washington-based Investment Company Institute.
Yields on 20-year general obligation bonds reached a 44-year low this month of 3.83%, according to the Bond Buyer 20 General Obligation Bond Index. The Build America Bonds program, which allows municipalities to issue taxable federally subsidized debt, has led some issuers to sell fewer tax-exempt bonds.
No 'Systemic Risk'
Average yields on Build America Bonds yesterday fell about 3 basis points, or 0.03 percentage point, to 5.48%, the lowest on record, according to data from a Wells Fargo index dating to August 26, 2009.
"I haven't seen any significant widening of credit spreads or inability to finance," Friedlander said in a telephone interview today. "Do I see any systemic risk for the U.S. economy coming out of this? No. I do see we're going into a more fiscally conservative political climate and state and local governments will be held to more rigorous standards of behavior than they have in the last 30 years."
Whitney's report rates the states on four criteria: the economy, fiscal health, housing and the flexibility to raise taxes. Florida, which has the second-highest U.S. foreclosure rate, according to RealtyTrac, is better off than New York or New Jersey, because it can adopt an income tax if necessary.
From 2000 to 2008, while states increased their spending by 60%, their revenue base increased by 45%. They bridged the gap by using federal aid, raiding their pension funds or by borrowing, Whitney said in a separate interview with Tom Keene on Bloomberg Radio.Avoiding 'Pain'
"You take on more leverage to avoid long-term pain," Whitney said.
U.S. states won't default, Whitney said. Instead, they will cut aid to local governments, putting them at greater risk. Local governments get one-third of their revenue from state transfers, Whitney said.
Still, debt service is also a limited portion of the budget for most municipalities. State and local governments will make $111 billion in interest payments on their debt this year, 5% of the $2 trillion they collect in taxes, according to the U.S. Commerce Department's Bureau of Economic Research.
State tax revenue has started to rebound. According to a survey by the NCSL, 40 states expect total tax collections in fiscal year 2011 to be higher than they were in 2010.