Let’s make one thing perfectly clear: Wall Street analyst Meredith Whitney is not crying wolf.

Whitney – who gained fame for correctly predicting the U.S. banking implosion that presaged a global credit crisis – is now warning us about defaults in the $2.9 trillion municipal bond market.

Whitney is being savaged for this latest prognostication, mostly by institutional money managers who resent the way that she’s roiled the traditionally sleepy “muni” market.

That’s as unfair as it is ugly . It’s unfair, because she’s correct: muni-bond defaults are headed our way. And it’s ugly because the naysayers – vested Wall Street interests that are only trying to protect their playground – are obscuring the truth.

[ad#Google Adsense]And with this dissembling, the Whitney-bashers are keeping disadvantaged individual investors from understanding the disaster at hand, and are likely dissuading these bondholders from avoiding the locomotive that’s steaming head-on at their portfolios.

Make no mistake: The so-called “deadbeat states” problem is real, and muni-bond defaults are almost certainly unavoidable.

Other Warnings

Whitney isn’t a lone voice in the wilderness. Indeed, JPMorgan Chase & Co. (NYSE: JPM) Chief Executive Officer Jamie Dimon recently said that there are significant problems facing munis and technical defaults have already happened. He ought to know. Big banks like the one that he runs actually “backstop” billions of dollars of muni obligations with letters of credit that they may not want to renew.

J ust this week, the bond rating of New Jersey – a noted deadbeat state candidate – was downgraded from AA to AA- by rater Standard & Poor’s Inc. According to a Bloomberg News report, S&P cited New Jersey’s growing pension and healthcare obligations as the catalyst for the downgrade. And even that state’s chief executive, Gov. Chris Christie, warned of the pain that’s almost certain to come.

“The clock is ticking away on a pension-and-benefit bomb that can damage the health of the finances of our state,” Gov. Christie, a first-term Republican, told his audience at a “town meeting” in Union City on Wednesday.

Under the Radar

The immediate, under-the-radar problem for the municipal -bond market is that borrowers relied on banks to backstop their credits and lower short-term funding costs when the credit crisis shut the door on auction-rate preferred financing.

Call it a legacy issue.

While most municipal borrowings are long term in nature, issuers still have short-term obligations that need to be rolled over. And while most of the states’ ratings remained intact during the crisis, investors demanded higher interest on the money they were loaning to even the strongest borrowers. To keep borrowing costs from soaring, municipal borrowers sought big bank letters of credit (LC) as backstop guarantees on the shorter- than- they- wanted variable-rate- demand obligations that they turned to.

According to Bank of America Merrill Lynch (NYSE: BAC), $109 billion worth of different kinds of credit backstops and guarantees will be expiring in 2011. Thomson Reuters estimates that $53 billion of those guarantees are bank letters of credit.

Of course, banks charge a fee for their letters of credit. But while they will likely increase the cost of their backstops significantly, no amount of fee income may be enough if they fear being left holding the bag on obligations that face potential default.

With municipalities and issuers of infrastructure bonds – including schools districts, hospitals and sewage and garbage- collection authorities -f facing uncertain tax and revenue receipts and inevitable downgrades, the risks they pose to guarantors could shut them out from low- interest- rate borrowings.

It’s not a small problem. There are 46 states – including New Jersey – that face an aggregate $140 billion in budget deficits for the 2011 fiscal year, according to the Washington-based Center on Budget and Policy Priorities. And this isn’t just a one-year wonder: The need to fund the retirements of public-sector employees will linger for years and will continue to have a “negative impact” on state credit ratings, rater Moody’s Investors Service (NYSE: MCO) said earlier this month.

That means that potential muni-bond defaults will be with us for a long time to come.

Rising rates on variable-rate demand obligations, which reset periodically, could be the straw that breaks the back of some muni issuers.

On top of the disdain that bankers have for increased exposure to the mounting woes of municipal finance authorities, the financial institutions face new risk-retention and capital-reserve requirements under the banking-reform law – the Dodd-Frank Wall Street Reform and Consumer Protection Act – that was enacted last July.

In the widely watched December segment of “60 Minutes” that thrust Whitney into the muni-bond spotlight, the analyst predicted that there could be as many as 100 significant defaults in the New Year – enough to total “hundreds of billions of dollars.”

In January, in a subsequent interview, Whitney conceded that she had no specific numbers to back that up. But that’s just part of the problem: It’s impossible to tell how much exposure banks have in this shadowy realm. You can’t find any breakout of their exposure to these types of letters of credit in bank financial statements. All it will take is one or two defaults to trigger write downs of their LC guarantees, which will then be followed by a loud call for transparency into what the banks are really holding.

A Calm Before the Storm

In total- return terms m unicipal bonds fell 5.4% in the three months ended Feb. 2, according to the Bank of America Merrill Lynch Municipal Master Index. Not surprisingly investors pulled $1.17 billion from muni-bond funds in the week that ended that same day (Feb. 2). That was the smallest amount since Dec. 1, according to the Investment Company Institute (ICI), but represented the latest in a string of several weeks of withdrawals.

That may well be due to the fact that Wall Street is telling investors that the drop in muni-bond prices has created the proverbial “buying opportunity.” Tax-exempt bonds posted a negative return for the fifth-straight month in January, which represents the longest-such decline since a skid that lasted six months back in 1999, the Bank of America Merrill Lynch index revealed .

Just this week, in fact, Bloomberg reported that Pacific Investment Management Co. and Cutwater Asset Management Corp. are “advising investors that record fund withdrawals amid projections of widespread municipal defaults have created a buying opportunity.”

“There’s been creeping risk, but there’s tremendous opportunity,” Cutwater CEO Clifford Corso told Bloomberg in an interview.

That brings us to the all-important bottom line of this controversy.

If short-term funding dries up along with desperately needed backstopping guarantees, borrowing costs for muni-bond issuers will rise and could trigger a cascade of events from downgrades to defaults.

And if that happens, then Meredith Whitney – the girl who cried wolf – will be back on “60 Minutes, ” huffing and puffing but this time burying her critics once and for all.

Actions to Take: Money Morning has published several in-depth analyses of the looming muni-bond crisis.

The first report was part of “Outlook 2011,” the annual economic-forecasting series that we publish each year for our readers. That story is available free of charge by clicking here.

The looming muni-bond crisis was also the focus of a recent “Question of the Week” feature. That article is available by clicking here.

Also, check out Shah Gilani’s interview on CNBC this week, when he took on the Wall Street establishment for ignoring the coming muni-bond crisis. That video can be accessed by clicking here.

— Shah Gilani

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Source:  Money Morning