$2 trillion municipal bond debt crisis could bring down 100 US cities, analyst warns

A new disaster is looming, according to a prominent market research analyst.

Meredith Whitney, a financial analyst who runs her own consulting firm and correctly predicted the major debt fallout of Citigroup, warned in a little-reported on interview Sunday that as many as 100 US cities face default on their municipal bonds.

Cities and states issue bonds to pay for public services. The trouble is that municipalities are no longer collecting enough in taxes to meet their budgetary needs. According to a 60 Minutes report Sunday -- which received almost no attention by the popular press -- US cities have spent nearly half a trillion more than they've collected in taxes, and face pension shortfalls of $1 trillion. Video of the CBS piece follows this article.

"Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy," Whitney told a CBS 60 Minutes' interviewer Sunday night.

"There's not a doubt on my mind that you will see a spate of municipal bond defaults. You can see fifty to a hundred sizeable defaults – more," Whitney added. "This will amount to hundreds of billions of dollars' worth of defaults."

Whitney became a household name in the investment community after issuing a dire report on Citigroup in 2007, prior to the global credit crisis. She predicted the bank would face a whopping credit crunch -- which it did -- and cut its dividend -- which it also did. The bank was subsequently forced to accept a massive government bailout.

Citigroup holds the most municipal bond debt out of all the banks in the US.

"Detroit is cutting police, lighting, road repairs and cleaning services affecting as much as 20% of the population," the Guardian's Elena Moya noted late Monday, writing about the 60 Minutes piece. "The city, which has been on the skids for almost two decades with the decline of the US auto industry, does not generate enough wealth to maintain services for its 900,000 inhabitants."

"The nearby state of Illinois has spent twice as much money as it has collected and is about six months behind on creditor payments," Moya added. "The University of Illinois alone is owed $400m, the CBS program said. The state has a 21% chances of default, more than any other, according to CMA Datavision, a derivatives information provider.

She continued: "California has raised state university tuition fees by 32%. Arizona has sold its state capitol and supreme court buildings to investors, and leases them back."

Municipal bond traders dismissed Whitney's concerns Monday as overblown on CNBC Monday.

“She’s being alarmist,” an unnamed "one of the largest municipal bond portfolio managers in the country" told CNBC.

“I can’t make the numbers work,” Ben Thompson, an industry titan who manages billions in tax-exempt bonds, added. “You’ve got to basically have New York, Chicago, Phoenix, Los Angeles—these cities start to default…the numbers just don’t add up.”

Some investors believe the default of a major city is low, arguing that states would be likely to bail out their beleaguered metropolises. States are not legally permitted for file for bankruptcy (though municipalities are).

But the municipal and state debt crisis is real, and not even the richest counties are immune. Earlier this month, The New York Timesreported on the affluent New York county of Nassau, where a Republican county executive -- "who won one of the first upsets of the Tea Party era" -- came into office and promptly cut taxes without trimming public benefits or services.

The county’s deficit now approaches nearly $350 million.

That things could get so dire in this wealthy county, where property taxes are the second highest in the nation, offers a lesson in what happens when anti-tax fervor meets the realities of disappearing revenues and a punch-drunk economy. At heart, though, the situation — like state budget crises in New York, New Jersey and Illinois — illuminates the troubles long-prosperous governments, with established interest groups and residents accustomed to high levels of services, face in adapting to protracted lean times.

“It’s the crisis of affluence,” said E. J. McMahon, director of the Manhattan Institute’s Empire Center for New York Policy. “It’s not just a problematic old inner city that can’t get out of its old way of doing things,” he said. “What makes Nassau a microcosm of New York State is its high spending, high taxes, intransigent unions, a pronounced taste for debt, and a sense that too many people in both parties have a stake in keeping it all that way.”

In June, New York state announced that they would borrow from the state's pension fund to make current payments to the fund, a maneuver that the New York Times described as a "sleight of hand."

"Pension costs for the state and municipalities are soaring, a result of enhanced retirement benefits for public employees and the decline in the stock market over the past two years," the Times Danny Hakim wrote in June. "And, given declines in tax revenue and larger budget shortfalls, the governments are struggling to come up with the money to make the contributions."

"Under the plan, the state and municipalities would borrow the money to reduce their pension contributions for the next three years, in exchange for higher payments over the following decade," Hakim continued. "They would begin repaying what they borrowed, with interest, in 2013.

"The maneuver would cost the state and local governments about $1.85 billion in interest payments, according to an estimate by the State Senate, though a number of factors could drive interest payments up or down," Hakim added.

In settling charges that they defrauded the municipal bond market in a bid-rigging scheme, Bank of America Corp. said earlier this month that it would pay over $137 million in restitution to schools, hospitals, counties, state attorneys and the Internal Revenue Service, among others.

Assistant Attorney General Christine Varney, antitrust chief at the US Department of Justice, warned that Americans would see "a lot more activity in the coming weeks and months" on municipal bond enforcement.

In an email to Bloomberg, Howard University law professor Andrew Gavil said that Bank of America's settlement was "likely the tip of the iceberg" and their conspirators were likely to face even larger fees.

Bank of America had been assisting the government's probe of the bond markets after self-reporting the alleged fraud. Varney said the probe was ongoing.

More than a dozen other firms including JPMorgan Chase & Co., UBS AG, and Societe Generale were also noted as unindicted co-conspirators.

This video is from CBS' 60 Minutes, broadcast Dec. 19, 2010.

Stephen C. Webster contributed to this report.