Meredith Whitney was an obscure Oppenheimer & Co. bank analyst back in 2008 when she broke from the pack and predicted Armageddon. She was right, the pack was wrong, and she parlayed her new-found fame into a research boutique of her own.

Last year she went for it again, predicting that the next big crisis would be in municipal bonds, as U.S. cities, counties and states ran out of money and started defaulting. This call didn't pan out as quickly:

Meredith Whitney Loses Credibility as Muni Defaults Fall 60%
July 15, 2011 -- Time is running out on the credibility of Meredith Whitney, who has yet to acknowledge that her eight-month-old prediction of widespread defaults this year in the market for state and local government debt is proving unfounded.

Defaults fell 60 percent in the first half of 2011 compared with the same period last year, including a $12.5 million Austin, Texas, apartment project that made a late payment in June, according to Distressed Debt Securities Newsletter.

Meredith Whitney, 41, who started New York-based Meredith Whitney Advisory Group LLC in 2009 after leaving Oppenheimer & Co., predicted 50 to 100 "sizable" municipal defaults as states slashed spending, in the interview with CBS Corp.'s "60 Minutes."

Whitney, the analyst who rose to prominence by predicting Citigroup Inc.'s 2008 dividend cut, predicted "hundreds of billions of dollars" of municipal defaults within 12 months in a Dec. 19 "60 Minutes" broadcast, fueling a wave of selling in the $2.9 trillion market. Instead, the number has fallen as cities slashed spending to balance budgets and state lawmakers stepped in to guard against insolvency and local bankruptcies.

"The data is not helping Meredith," said Matt Fabian, a managing director at Municipal Market Advisors, a financial- research company based in Concord, Massachusetts. "It's always been a possibility there would be a wave of defaults. You can't say that it's zero but it's given no sign of starting."

But fast forward a year and Whitney's looking pretty smart. A wave of California cities have gone bankrupt, with more around the country in the pipeline. Consider this from yesterday's Wall Street Journal:

Hard Times Spread for Cities
Fiscal woes that have caused high-profile bankruptcies in California are surfacing across the country as municipalities struggle with uneven growth and escalating health and pension costs following the worst recession since the 1930s.

Budget crunches already have prompted Michigan lawmakers to authorize emergency fiscal managers, and led the mayor of Scranton, Pa., to temporarily cut the pay of all city workers to the minimum wage.

In a majority of the nation's 19,000 municipalities--urban and rural, big and small--stagnant property tax revenues, less aid from states and rising costs are forcing less dramatic but still difficult steps.

Moody's Investors Service recently said that while municipal bankruptcies are likely to remain rare, it warned of a "a small but growing trend in fiscally troubled cities unwilling to pay their debt obligations."

"We need help right now," said William Schirf, the mayor of Altoona, Pa. Crime in the city of 46,000 rose 11% last year, while the number of police officers fell 8% over three years because of budget constraints. The city has reduced the number of streets it is repaving and clearing of snow, and cut down on leaf pickups and removing dead animals, trash and bicycles from roadways.

Altoona officials projected a $3 million deficit for fiscal 2012. Under state law, the city can't raise property taxes--its greatest source of revenue--any higher. In April, Altoona was declared fiscally distressed under a state law, enabling it to restructure its finances. "We just don't have the income to match our expenses," said Mr. Schirf.

A study by the Center for Retirement Research at Boston College found that annual pension payments for state and local plans more than doubled to 15.7% of payrolls in 2011 from 6.4% a decade earlier.

The Nelson A. Rockefeller Institute of Government said local governments made roughly $50 billion in pension contributions in 2010, but their unfunded pension liabilities still total $3 trillion and unfunded health benefit liabilities are more than $1 trillion.

Local government cuts are one factor slowing the broader economic recovery, offsetting stronger private-sector growth. State and local government spending and investment fell at a rate of 2.1% in the second quarter, according to the Commerce Department, the 11th consecutive quarterly drop. Local governments also have cut 66,000 jobs in the past year, mostly teachers and other school employees.

"Cities are still going to be facing very rough waters for the next couple of years," said Michael Pagano, dean of the college of Urban Planning and Public Affairs at the University of Illinois at Chicago.

Princeville, N.C., a small town in the eastern part of the state, handed control of its books to a state commission in late July after struggling to pay for water system updates. The town temporarily turned off water services to about 200 homes, but many residents said they couldn't afford the higher bills.

There also was a backlash in Michigan after Gov. Rick Snyder won legislative approval of a measure that allowed him to appoint emergency managers for troubled cities and school systems--allowing collective-bargaining agreements to be tossed. Voters will decide in November whether to repeal the law.

To boost revenues, cities are increasing fees and property taxes--where they can. In Chicago, private investors are investing in public infrastructure projects. El Monte and Richmond, Calif., want to tax soda.

Indeed, while housing is showing signs of improvement, real estate assessed values remain depressed, eroding property tax receipts, which provide 29% of revenue for municipalities, according to a Moody's analysis of census data. State aid, the biggest source of revenue for local governments at 34%, is falling and the growth of receipts from wage, sales and other taxes, which provide 10% of local budgets, is slowing.

At the same time, pension and health-care costs are rising despite efforts to restructure those benefits. The most vulnerable cities are ones that experienced drastic reductions in property values or are in states like California that limit municipal options to increase revenues. In addition, nearly a third of California cities require collective bargaining and prohibit outsourcing of administrative and maintenance services.

Since 2008, four California municipalities have filed for bankruptcy protection--Vallejo, Stockton, Mammoth Lakes, and most recently, San Bernardino, which declared bankruptcy Aug. 1, in large part because sales and property taxes fell after the real estate bust. The assessed value of homes in San Bernardino dropped to $10.3 billion in 2011 from $12.2 billion in 2008.

On top of a declining property tax base, the city has faced a significant drop in sales tax collections since 2005. Economist John Husing said San Bernardino's retail sales fell 30% during that period. Likewise, a decline in construction means less revenue from things like building permits and development fees.

While many municipalities nationwide have offset property-tax declines by raising tax rates, California's 1978 law dubbed Proposition 13 caps property taxes at about 1% of a home's value and forbids major tax increases unless a home is sold or rebuilt, though it permits taxes to fall if a home's value drops.

Residents in El Monte, Calif., 15 miles east of Los Angeles, will vote in November on a soda tax that could raise about $10 million annually. The city, which lost four major car dealerships that generated a large share of the city's sales tax revenue, cut nearly 30% of its workforce to help close a $3 million budget deficit but still faces $2 million deficit for the current year.

Local merchants oppose the measure. "I'm struggling to stay open and here they want to tax me even more. It's crazy," said Arthur Meier Jr., who owns Arts World Famous Burgers in El Monte.

Elsewhere, the cost of shoring up underfunded pension plans for public workers is going slowly. In many states, benefits are guaranteed and difficult to modify unless a city is declared "fiscally distressed." "Because of the guaranteed nature of benefits, there's no quick fix," said Thomas Fitzpatrick, an economist with the Federal Reserve Bank in Cleveland.

Steven Kreisberg, collective bargaining director at the American Federation of State, County and Municipal Employees, the nation's biggest public-sector union, said pension problems were caused by investment losses that can be gradually recovered, rather than due to overly rich benefits. "When you lose 20% of your assets in a single year that's what created the problem," he said.

Providence, R.I.'s $423 million pension system staved off bankruptcy after reaching a tentative deal in May to cut pensions for retirees and current police, firefighters, and municipal laborers, resulting in a savings of about $18.5 million a year. Its pension plan was expected to consume about 20% of city tax collections in fiscal year 2012.

Pensions were "unaffordable and unsustainable," said Mayor Angel Taveras, a Democrat, who lowered his own salary 10%, cut 200 city employees, closed five schools, and secured $40 million in voluntary payments from tax-exempt universities and hospitals, including Brown University.

In Chicago, Mayor Rahm Emanuel, facing a projected $369 million budget gap, created an infrastructure trust backed by financial companies including J.P. Morgan Asset Management and Citibank. The investors will put up $1.7 billion for projects approved by a five-member board, the first being considered is a $200 million energy retrofit of city buildings expected to save $20 million a year in heating bills.

Boston is increasing property assessments of tax-exempt organizations like universities, while Maryland passed a law allowing cities to assess a storm water fee to help pay for projects to clean up the Chesapeake Bay.

Other cities like Cleveland and St. Louis are imposing new fees for city services, such as trash collection. Such fees "can better link the funding of services to people that actually experience the benefit" said Michael Nadol, managing director with Public Financial Management, who advises municipalities on fiscal issues.

Some Thoughts

This is another example of easy money distorting price signals and leading people to behave in ways that, in retrospect, look extremely stupid. It worked like this: Washington ran consistent, large deficits and/or kept interest rates artificially low, which raised the nominal returns on stocks, bonds, and real estate and led city officials and union leaders to think that they could get away with sweetheart contracts featuring insanely generous pensions and health benefits.

Then, when things got a bit tight, these same municipal and union officials the rolled dice and refrained from fully funding these plans in order to avoid telling hard truths to taxpayers. A few years of this and the imbalances have become so insurmountable that the only solutions are 1) absolutely devastating cuts in services that are the reason city governments exist, 2) defaults on the bonds that cities used to finance their overspending, and 3) eventual bankruptcy in which public sector unions are stripped of the pensions that they assumed were written in stone.

Muni bond investors, meanwhile, will discover that the "risk free" parts of their portfolios are anything but, leading to harder times for retirees and some wild capital migrations out of munis and into...who knows?

The cumulative result is lower living standards for almost everyone. Private sector workers who are spared the immediate public sector wage/benefit cuts will still have crumbling schools, cops and firefighters stretched too thin to respond on time, bad roads, libraries with empty shelves and erratic hours, etc., etc. All the pathologies, in other worlds, of a country that hasn't yet developed into a nice place to live.

Except that we're regressing to this stage, which will be much harder psychologically. As the old saying goes, it's easier to be poor if you've never been rich.

At the risk of belaboring the point, the real culprits aren't living in these cities. They're in Washington, still at work distorting the monetary system for their own gain, trying their best to fool the rest of us into even more malinvestment.