Meredith Whitney? She Was Right

Meredith Whitney

FORTUNE -- To readers of the business press, the story is a familiar one: fifteen months ago, superstar analyst Meredith Whitney rocked the world of municipal finance with a December 2010 prediction on 60 Minutes that a wave of municipal debt defaults was headed our way. Her forecast was quite specific: "You could see fifty to a hundred sizable defaults," she told her interviewer, correspondent Steve Kroft. "This will amount to hundreds of billions of dollars' worth of defaults."

The bottom fell out of the muni bond market as a result. Investors pulled some $14 billion from muni bond funds between December 22 and February 2, 2011, and returns in the fourth quarter of 2010 were the lowest in 16 years. Long-time players in the space, including analysts, fund managers, and muni brokers, reacted with indignation that an arriviste such as Whitney—the woman who made her name calling out Citigroup (C) as an emperor with no clothes at the dawn of the mortgage crisis—dared to try to expand her analytical purview into their cozy little corner of the capital markets.

She was wrong, they said. She didn't know squat about how their market worked. The kind of defaults she called for were never going to happen. And they were right, in the most literal sense. Since then, there have only been $2.6 billion in defaults from the $3.7 trillion market. And the muni bond swoon didn't even last very long: in 2011, Barclay's muni bond index returned 10.7%, more than five times the 2.1% return of the S&P500.

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Nothing satisfies like a comedown of a prominent prognosticator, and Whitney has taken her lumps in both the business press and the more unbridled blogosphere ever since. She deserves at least some of it, but that's only for being overly specific. The more general point that she was trying to make—that municipal finances in this country were a mess that was only going to get messier—was dead on. Laugh at her all you want, but then try this: go find one person who says their local taxes are falling or their municipal services have improved in the past year or two. I wish you luck in your endeavor.

"States have pushed more and more expenses down to the local level," Whitney tells Fortune. "And municipalities don't have the money to make up the difference. That is where you see the real strain, especially after the American Reinvestment Recovery Act expired in June 2011."

Whitney's September 2010 report on municipal finances didn't contain a single call on a specific municipal bond. Indeed, the 1,400-page beast of analysis, titled "The Tragedy of the Commons," was instead focused on delineating the myriad—and slightly terrifying—financial obligations that the largest states in the country were having increasing trouble meeting. Something had to change, she said. And something did. It just wasn't as simple as a bunch of outright defaults.

When the criticism came raining down on her in early 2011, Whitney explained that she didn't just mean "technical" bond defaults but also mushier terms such a "social contract defaults"—e.g. less frequent trash removal schedules—and "employment contract defaults"—e.g. government employees being forced to contribute to their own pensions. Whether you think she tried to change the conversation after the fact or was merely elaborating is really neither here nor there. Because all of that is happening, and more. Municipal bond brokers may still find the time to chuckle about Whitney's comeuppance, but if you're someone responsible for actually dealing with the real-life implications of deteriorating muni finances, the mirth becomes a little harder to come by.

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"States are regular bond market issuers, so they do care about their debt ratings, and have done everything they can to prevent public attention focusing on their crises," Whitney says. "They've even taken cities into receivership to prevent them from going bankrupt. But municipalities are only occasional issuers. They're much less concerned with bond market ratings than with the real pain they're already suffering."

Alabama's Jefferson County has actually gone bankrupt. Stockton, California is all but ready to do the same. And all you have to do is look to Detroit—or any of the nearby auto towns named after a Buick model of one sort or another—and you see fiscal crisis playing out right now. Look in your own backyard—or at the potholes on your neighborhood roads—and you will likely find the same.

Consider the email I received on March 7 from former New York State Assemblyman Richard Brodsky about Yonkers Mayor Mike Spano's recently formed Commission of Inquiry into what he refers to as that city's "Great Unraveling." (Brodksy is serving on the commission.)

"[Yonkers has] a budget of about $1 billion and a budget gap in the upcoming year that looks like it can't be bridged. There are reasons aplenty. Like may urban centers the Yonkers manufacturing base disappeared, the middle-class moved out and the people simply can't afford the property and sales tax burden that ensured. Anti-tax fervor hit and elected officials refused to raise recurring revenues. Gimmicks, one-shots, borrowing for operating expenses, assets sales, and assorted maneuvers 'kicked the can down the road' for a couple of years…The city has now run out of gimmicks."

And then he sounds very Whitney-like: "It's as though we stand on the shore and watch a tsunami gather and shrug and hope we'll get through it…That needs to change, and if the list of endangered cities gets larger this will force itself onto the national stage. [For now] the great national battle about the size of government and the level of taxation will be played out in the streets of small cities across America, with school kids, garbage pick-up, fire-protection, and safe streets competing with each other for inadequate resources. It's an ugly way to solve a problem."

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In late February, Whitney signed a deal to write a book about the trouble that isn't going anywhere, even if her bond-market prediction was a misfire. Titled Downgraded: Why the Next Economic Crisis Will Be Local, it's on a fast turnaround for November publication.

Whitney isn't that interested in talking about her words on 60 Minutes anymore—why would she be?—but it's hard to argue with the fact that a prominent voice succeeded in bringing more focus to a real and pressing issue and helped change the conversation. Thirty-six freshly elected governors were listening in 2010. Or at least a few were—the likes of New Jersey's Chris Christie, Florida's Rick Scott, and Indiana's Mitch Daniels—but they and their successors are going to be playing the fiscal prudence game for years to come.

I have argued at length and one more than one occasion with Whitney that she made a mistake when she got too precise on TV. She doesn't agree. But we do find common ground about the fact that continuing to play "Gotcha!" over those 20 or so words is missing the forest for the trees. "Look at Greece," she says. "They're not in technical default. That doesn't change the fact that it's the biggest sovereign debt writedown in history. It's all the same in the end."

Posted in: Macro, meredith whitney More from Term Sheet Juggernaut Capital raising $300 million A third bailout for Greece seems inevitable Trimaran claws at its own investors View all 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=finance&cnn_money_section=blogs&cnn_money_subsection=term_sheet&page.allowcompete=no"); About This Author Duff McDonald Contributing Editor, Fortune

Duff McDonald is a contributing editor at Fortune. He has also written for New York, Vanity Fair, Condé Nast Portfolio, GQ, WIRED, Time, Newsweek, and others. In 2004, he was the recipient of two Canadian National Magazine Awards -- best business story (gold) and best investigative reporting (silver) -- for "Conrad's Fall" in National Post Business. Last Man Standing, his biography of Jamie Dimon, chairman and CEO of JPMorgan Chase, was published by Simon & Schuster in October 2009. He is also the co-author, with Owen Burke, of The CEO, a satire.

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