FORTUNE -- Meredith Whitney is issuing a fresh warning to mutual funds, banks, and politicians: The state of state finances is far worse than what you think, or at least than what you've been willing to tell the investors and taxpayers who will eventually carry the burden. In a new report released today to her clients, Whitney summons what appears to be the most comprehensive set of data ever assembled on state budgets and debt.
Meredith Whitney, still focused on state finances.
Her conclusion is that the future deficits that need to be closed, either by new taxes or draconian cuts in social services, are far bigger than the official numbers show, and that debt levels, when all liabilities are counted, vastly exceed the official estimates.
Late last year on 60 Minutes, Whitney predicted hundreds of billions in defaults on municipal bonds in the next five years. That controversial call was widely condemned, especially on Wall Street, where the muni market is an enormous profit spinner.
Now, Whitney tells Fortune she never meant to make more than a general forecast. "I never intended on framing the scale of defaults as a precise estimate, but I continue to believe that degree of municipal defaults will be borne out over the cycle. I meant to point out that the state debt problem is a massive headwind for the U.S. economy, second in importance only to housing."
Whether you agree with it or not -- and she's still getting little support from rating agencies or anywhere else -- the numbers she's assembled, and the risks they pose, are daunting.
Whitney's latest report is even more thorough than last year's analysis that started the uproar. It covers 25 of the largest states, adding ten new ones to the list, including Arizona, Nevada, Connecticut, and Wisconsin. The problem starts with spending. Since 2003, state governments have raised annual outlays from $1.5 trillion to almost $2.2 trillion, or $700 billion, yet tax receipts have risen only $400 billion or $300 billion less, to $1.4 trillion. In fact, spending kept surging all during the recession, while income from sales, income and corporate taxes went totally flat in 2007.
Three big problems, no solution
But 46 states are obligated to balance their budgets each year. So how are they bringing receipts in line with spending when taxes fall 36% short of revenue? And remember, this gap is growing despite big tax increases that are becoming more and more difficult. The states are getting that extra money from three sources. First, the federal government enormously increased aid to the states under the stimulus or American Recovery and Reinvestment Act. Since 2009, the ARRA has delivered $480 billion in grants and contracts, padding over one-third of their combined deficits. But the last stimulus dollars expire this month.
Even with a historic increase in federal assistance, the states have relied on two additional measures to plug the remainder of the shortfall -- measures that will be harder and harder to repeat. The states tapped "rainy day" funds or surpluses reserved for emergencies. Their governments used $9 billion of that cash in 2010, with Connecticut totally exhausting its $1.4 billion in reserves, and Pennsylvania tapping its emergency savings for $755 million.
Second, the states have immensely increased their issuance of General Obligation bonds that fund what corporations strive to avoid -- paying operating expenses with long-term debt. Those securities are backed exclusively by state tax revenue. In 2000, the states issued $67 billion in GO securities; last year, they raised $148 billion from those bonds. While Whitney acknowledges that this class of securities is unlikely to see defaults, they still place a huge burden on the future. The reason: Fixed interest expenses are absorbing a bigger and bigger share of state budgets, leaving a shrinking portion for everything else.
Today, debt service absorbs half of Nevada's budget, and 40% of Michigan's. In Arizona, California, Connecticut, Ohio and Illinois, the share now exceeds 20%.
The third and biggest problem, pension costs, both increases current cash expenses and artificially understates what the states should be spending today. Even by putting the minimum into their pension funds, they're still crowding out spending for everything else because the costs are rising so fast. Hence, it ensures that future tax increases and spending cuts will be far greater than advertised. The states are systematically underfunding their pensions. Today, they cover 77% of their future liabilities versus 103% in 2000. If they fully paid their annual pension costs, the states would need to increase spending by over $700 billion a year, or over 40% of their current outlays.
And those figures don't include future spending on health care costs, falling into a little-known category called OPEB or Other Post Employment Benefits. Most states simply pay these OPEB costs directly from revenues. No actual income-generating funds, accumulated for the future, back them in most states. New Jersey, New York, Connecticut and Illinois are all pay-as-you go states with totally unfunded OPEB liabilities. As those costs inevitably swell, they will apply even more pressure to state budgets.
Giant shadow of debt
Whitney also presents a startlingly bleak picture of state debt. States have two types of liabilities that are fully backed by tax revenues. One is on-balance sheet, and the other is excluded from the states' books. The first type is the General Obligation bonds that fund salaries and current expenses. Those are fully visible to investors. But the bigger problem is the giant shadow cast by the pension and OPEB liabilities that are absent from balance sheets. In fact, states weren't even required to report the OPEB number at all until 2008, and the pension figure is consistently understated because states generally far overestimate future returns on their retirement funds.
As Whitney shows, these off-balance sheet numbers are an incredible three times the size of all on-balance sheet debt, totaling $2 trillion. The load is rising quickly; the unfunded pension burden has jumped 50% in the past year.
Naturally, some states are far healthier than others. Indiana, says Whitney, is a "model citizen," while California and New Jersey already face such high tax rates that they have little room, or political will, to raise more revenue. The danger is a continuation of what's already happening, what Whitney calls "state arbitrage," in which the low-tax, business friendly venues such as Texas and North Carolina keep drawing companies and workers from the fiscally-challenged states. That could cause a vicious cycle where the weak get even weaker as their tax bases erode, and the strong reap the rewards from fiscal prudence.
The damage from state arbitrage could increase the scale of defaults in the second type of municipal securities: Revenue Bonds. Once again, Whitney sees little threat to General Obligation bonds because states simply won't default. What the fiscal calamity calls in doubt is Revenue Bonds that back specific projects such as subsidized housing, toll roads, land acquisitions, and nursing homes. Those bonds are supported by the cash flows from the projects themselves, and they aren't guaranteed by the state governments. So if the cash flows fall short of the interest payments, they need to be restructured -- at a big cost to the investors who own them. And the revenue bonds now dwarf general bonds in total volume, totaling $2.7 trillion, versus $1.4 billion for the GOs.
Whitney points out that Florida has issued 90% of its municipal offerings in revenue bonds, many tied to real estate. Those real estate-related securities are the most vulnerable. Only time will tell if the "hundreds of billions" figure Whitney ventured on 60 Minutes will materialize. But her report shows that of all the problems investor and politicians are worried about, the mess in state finances is one of the most dangerous, and certainly the most overlooked.
Posted in: bonds, deficit, Macro, meredith whitney, Municipal bond Print RSS More from Term Sheet Venture capital returns: The best, and then the rest The government's risky SAC wager Meredith Whitney: State finances are worse than estimated View all CNNMoney.com Comment Policy: CNNMoney.com encourages you to add a comment to this discussion. You may not post any unlawful, threatening, libelous, defamatory, obscene, pornographic or other material that would violate the law. Please note that CNNMoney.com may edit comments for clarity or to keep out questionable or off-topic material. All comments should be relevant to the post and remain respectful of other authors and commenters. By submitting your comment, you hereby give CNNMoney.com the right, but not the obligation, to post, air, edit, exhibit, telecast, cablecast, webcast, re-use, publish, reproduce, use, license, print, distribute or otherwise use your comment(s) and accompanying personal identifying information via all forms of media now known or hereafter devised, worldwide, in perpetuity. CNNMoney.com Privacy Statement. Join the Conversation Follow Fortune Magazine cnnad_renderAd("http://ads.cnn.com/js.ng/site=cnn_money&cnn_money_brand=fortune&cnn_money_pagetype=blog&cnn_money_position=336x600_rgt&cnn_money_rollup=markets_and_stocks&cnn_money_section=blogs&cnn_money_subsection=term_sheet&page.allowcompete=yes"); About This Author Shawn TullyShawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.
Email Shawn From the CrowdCommentary and analysis from outside voices in venture capital, hedge funds and economicsGroupon IPO: Mind the ratiosWhat to make of Peter Thiel's "20 Under 20"³ programThe rebirth of asset-based lendingHow to know if your business will scaleThe startup genome project Featured Newsletters Today in Tech Every morning, discover the companies, deals and trends in tech that are moving markets and making headlines. Subscribe The Term Sheet Receive Fortune's newsletter on all the deals that matter, from Wall Street to Sand Hill Road. Subscribe Ask Annie Anne Fisher answers career-related questions and offers helpful advice for business professionals. Subscribe See all newsletters cnnad_renderAd("http://ads.cnn.com/js.ng/site=cnn_money&cnn_money_brand=fortune&cnn_money_pagetype=blog&cnn_money_position=336x280_bot&cnn_money_rollup=finance&cnn_money_section=blogs&cnn_money_subsection=term_sheet&page.allowcompete=yes"); Markets MarketMovers USIndices Company Price Change % Change Microsoft Corp 24.01 0.10 0.44% Frontier Communicati... 8.18 0.00 0.00% International Busine... 164.75 -0.30 -0.18% Public Service Enter... 32.04 0.00 0.00% Becton Dickinson And... 84.80 0.00 0.00% Data as of Jun 6 Index Last Change % Change Dow 12,089.96 -61.30 -0.50% Nasdaq 2,702.56 -30.22 -1.11% S&P 500 1,286.17 -13.99 -1.08% Treasuries 3.00 0.01 0.17% Data as of 5:06am ET Most Popular cnnad_createAd("383053","http://ads.cnn.com/html.ng/site=cnn_money&cnn_money_position=314x30_spon&cnn_money_rollup=business_news&cnn_money_section=social_media&cnn_money_subsection=most_popular¶ms.styles=fs&page.allowcompete=yes","30","314"); Stocks slip on investor jitters Your Verizon iPhone isn't as good as an AT&T iPhone 3-D printers will be your next home accessory Obama's chief economic adviser leaving Apple launches its iCloud Job Search Accounting jobs Engineering jobs Finance jobs Management jobs Marketing jobs Sales jobs See all jobs cnnad_createAd("469702","http://ads.cnn.com/html.ng/site=cnn_money&cnn_money_pagetype=blog&cnn_money_position=336x280_quigo&cnn_money_rollup=markets_and_stocks&cnn_money_section=blogs&cnn_money_subsection=quigo¶ms.styles=fs&page.allowcompete=yes","280","336"); /* */ About CNNMoney Contact Us Advertise with Us User Preferences Career Opportunities Conferences Business Leader Council Content Fortune Magazine Money Magazine Business News Markets Term Sheet Economy Tech Personal Finance Small Business Video Magazines Subscribe to Fortune Subscribe to Money Give the Gift of Fortune Give the Gift of Money Reprints Special Sections Magazine Customer Service Site Tools Site Map Watchlist Search Jobs Real Estate Search Mortgage and Savings Center Calculators Widgets Corrections Market Data Alerts News Alerts Stay Connected My Account Mobile Site & Apps Facebook Twitter LinkedIn YouTube RSS Feeds Newsletters Tumblr Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2011 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2011 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2011. All rights reserved. Most stock quote data provided by BATS. © 2011 Cable News Network. A Time Warner Company. All Rights Reserved. Terms under which this service is provided to you. Privacy Policy. Ad choices . var R = new String(document.referrer); var serveAd=1; if(R.length > 0) { if (R.indexOf("yahoo.com") >= 0) serveAd=0; } if(serveAd) { // dynamic logic document.write(''); cnnad_createAd("229469","http://ads.cnn.com/html.ng/site=cnn_money&cnn_money_position=1x1_bot¶ms.styles=fs","1","1"); try { selectSurvey(); } catch(e){} } _qoptions = {qacct:"p-5dyPa639IrgIw"}; document.write( ''); _qacct="p-5dyPa639IrgIw";quantserve(); document.write(unescape("%3Cscript src='" + (document.location.protocol == "https:" ? "https://sb" : "http://b") + ".scorecardresearch.com/beacon.js' %3E%3C/script%3E")); COMSCORE.beacon({ c1:2, c2:6035728, c3:"", c4:"", c5:"", c6:"", c15:"" }); //check for or create a namespace if (typeof CNN === 'undefined') { var CNN = {}; } if (typeof CNN.tracking === 'undefined') { CNN.tracking = {} } /** Adds an image ping beacon to the end of the HTML page. */ CNN.tracking.cnn_wpBlogPing = function() { var loc = window.location.href; var img = ''; $('body').append(img); }; $(document).ready(function() { CNN.tracking.cnn_wpBlogPing(); }); // toggle tabs function showNavTab(tabId,tabNo) { var tabCollection = document.getElementById(tabId); tabCollection.className='Tab'+tabNo+'Visible'; } Powered by WordPress.com VIP. // /* a.like').click( function(e) { e.preventDefault(); jQuery('#wpl-mustlogin').remove(); jQuery.post( 'http://finance.fortune.cnn.com/wp-admin/admin-ajax.php', { 'action': 'wpl_record_stat', 'stat_name': 'loggedout_like_click' } ); var tenMins = new Date(); tenMins.setTime( tenMins.getTime() + 600000 ); document.cookie = 'wpl_rand=a6af3a6cd8; expires=' + tenMins.toGMTString() + '; domain=wordpress.com; path=/;'; jQuery('#wpl-count').after( '\ \ \Just one more step to like this post:
\ Username \ Password \ \ \ \Not a member yet? Sign up with WordPress.com
\ \ \ '); jQuery('#wpl-mustlogin').hide().slideDown('fast'); } ); jQuery('#wpl-mustlogin input.input').live( 'focus', function() { jQuery(this).prev().hide(); }).live( 'blur', function() { if ( jQuery(this).val() == '' ) jQuery(this).prev().show(); }); jQuery('#wpl-mustlogin input#wp-submit').live( 'click', function(e) { e.preventDefault(); jQuery.post( 'http://finance.fortune.cnn.com/wp-admin/admin-ajax.php', { 'action': 'wpl_record_stat', 'stat_name': 'loggedout_login_submit' }, function() { jQuery('#wpl-mustlogin form').submit(); } ); }); jQuery('#wpl-mustlogin a#wpl-signup-link').live( 'click', function(e) { e.preventDefault(); var link = jQuery(this).attr('href'); jQuery.post( 'http://finance.fortune.cnn.com/wp-admin/admin-ajax.php', { 'action': 'wpl_record_stat', 'stat_name': 'loggedout_signup_click' }, function() { location.href = link; } ); }); }); /* ]]> */ _qoptions={qacct:'p-18-mFEk4J448M',labels:'language.en,type.wpcom,posttag.bonds,posttag.deficit,posttag.macro,posttag.meredith-whitney,posttag.municipal-bond,vip.fortunewallstreet'}; /* */ try{COMSCORE.beacon({c1:2,c2:7518284});}catch(e){} st_go({'blog':'12752207','v':'wpcom','user_id':'0','post':'19062','subd':'fortunewallstreet'}); function st_vt() {var x=document.createElement("img");x.src="http://stats.wordpress.com/g.gif?blog=12752207&v=wpcomvt&user_id=0&post=19062&subd=fortunewallstreet&rand="+Math.random();} ex_go({'crypt':'UE40eW5QN0p8M2Y/RE1BNmNJfGhxNCVxUDExYmtib2E/SzdEJm0lUEtXQmxPVWI5QS9mSTN0d084bWxRcDBTWHxqLTIrY35yV35XZ2NRZUMzX3ZiazRmYltwYyZ6cENQP3BdW09LcllHa3dhbjQsWHV1a29YajZqblJrX2FkZ0xxTTJCSGhfYURtT2w0P2lFQ1g2Zy1Wfmg0NW5pV3ouN35xb2hsQkRWdCVvQUo5SEYzU05jK3ZjMlI/LmppJjM5bTU0UmRbTnIyckFXci55Wg=='}); addLoadEvent(function(){linktracker_init('12752207',19062);}); Read Full Article »