Back in 2006 Meredith Whitney was an obscure Wall Street analyst who bit the hand that fed her by declaring housing a bubble and the big banks a disaster. This took guts, both because analysts who dis their research universe tend to lose access and/or their job, and because the overwhelming consensus, from Alan Greenspan on down, held that things were fine, home ownership was good, and big banks were rock-solid.

Whitney was right, they were wrong, and since then she's used her considerable cred to keep hammering away at the illusion of a recovering US financial system. Her current target is state and local finances, which, she says, are far worse than the mainstream realizes. In today's Wall Street Journal she lays out this thesis and asserts that a federal bailout isn't coming -- it's already here.

I intended to post a few excerpts, but couldn't find a single paragraph that didn't contain something useful. So here's the whole thing:

State Bailouts? They've Already Begun

Bond subsidies and transfers have allowed states to avoid making tough decisions. It won't last.

The threat posed by the state fiscal crisis in the U.S. is vastly underestimated and under-appreciated--because even today too few people understand how states have been managing their finances.

A clear example of this took place in Manhattan last week at the Economist magazine's Buttonwood Conference, where a panel role-played the federal government's response to a near default of the hypothetical state of New Jefferson. After various deliberations and simulated threats from the Chinese government, the panel reluctantly voted to grant New Jefferson an emergency bailout of $1.5 billion to cover the state's debt payment.

What this panel and so many other investors fail to appreciate is that state bailouts have already begun. Over 20% of California's debt issuance during 2009 and over 30% of its debt issuance in 2010 to date has been subsidized by the federal government in a program known as Build America Bonds. Under the program, the U.S. Treasury covers 35% of the interest paid by the bonds. Arguably, without this program the interest cost of bonds for some states would have reached prohibitive levels.

California is not alone: Over 30% of Illinois's debt and over 40% of Nevada's debt issued since 2009 has also been subsidized with these bonds. These states might have already reached some type of tipping point had the federal program not been in place.

Beyond debt subsidies, general federal government transfers to states now stand at the highest levels on record. Traditionally, state revenues were primarily comprised of sales, personal and corporate income taxes. Over the years, however, federal government transfers have subsidized business-as-usual state spending not covered by state tax collections. Today, more than 28% of state funding comes from federal government transfers, the highest contribution on record.

These transfers have made states dependent on federal assistance. New York, for example, spent in excess of 250% of its tax receipts over the last decade. The largest 15 states by GDP spent on average over 220% of their tax receipts. Clearly, states have been spending at unsustainable levels without facing immediate consequences due to federal transfer payments and other temporary factors.

At the same time, local governments now rely on state government transfers for 33% of their funding. Thus, when a state finds itself in a financial bind, it has the option of saving itself before saving one of its local municipalities. Pennsylvania recently assisted the state capital, Harrisburg, in the form of a one-time "advance" payment--but there are hundreds of towns like Harrisburg that will also need assistance. These one-time fixes fail to address the real structural problems facing so many states and municipalities.

State budgets are likely to experience their second consecutive year with deficits of close to $200 billion. The root of the problem is simple: State governments have spent recklessly and unsustainably. Rainy-day funds are depleted, pension-fund contributions are already at record lows, and almost all of the major federal government subsidy programs will run out in June 2011.

Until now, the states have been able to evade the need to rein in spending largely because the federal government enabled them to do so through record high federal allocations, and by creative accounting that put off funding well over a trillion dollars of state-employee pension and other retirement obligations.

The level of complacency around this issue is alarming. Most assume, as last week's Buttonwood panel did, that the federal government will simply come to the rescue of the states without appreciating the immensity of the cumulative state-budget gaps. I expect multiple municipal defaults to trigger indiscriminate selling, which will prompt a federal response. Solutions attempted in piecemeal fashion, as we've seen thus far, would amount to constantly putting out recurring fires.

Rather than waiting for more federal intervention, states need to make their own hard decisions and not kick the can down the road. How will taxpayers from fiscally conservative states like Texas or Nebraska feel about bailing out threadbare Illinois or California? Let's hope we never have to find out.

Some thoughts:

• When you add up state and local pension liabilities, operating fund deficits and outstanding muni bonds, the bailout numbers become Fannie/Freddiesque. We're talking several trillion dollars up front, with no end in sight because states will use federal money to avoid the kinds of changes that would bring them back into a semblance of balance.
• The size of this ongoing federal commitment will be obscured in the official announcements -- as it is now -- but analysts like Whitney will see through the lies and publish real numbers. So eventually the markets will understand that Washington, just a few years after nationalizing the mortgage market, has taken on another several trillion dollars of junk paper from the states.
• The global markets, already worried about the viability of the dollar as a reserve asset, will really start to sweat. The question is how they're react to this latest assault on their collective balance sheet. Foreign central banks and risk-averse investors are starting to resemble battered spouses, putting up with pretty much anything from the US because they have nowhere else to go. But even this kind of pathological patience has to have a limit, and if a bailout of California and Illinois is the final straw, then the game changes from fiscal crisis to currency crisis.