Meredith Whitney: Detroit as precedent to the staggering aftershocks of the largest municipal bankruptcy in US history

Bank analyst Meredith Whitney who correctly called on the Citibank fiasco during the 2007-2008 crisis warns in the Financial Times that  the Detroit episode serves as precedent to a coming wave of municipal bankruptcies. (bold mine)

As jarring as the reality may be to accept, Detroit’s decision last week to declare bankruptcy should not be regarded as a one-off in the US municipal market – which is what the bond-peddlers are now telling their clients. The aftershocks of the largest municipal bankruptcy in US history will be staggering, and Detroit will set important precedents.

Municipal bankruptcies have historically been rare for a number of reasons – including the states’ determination to preserve their credit ratings, their access to cheap funding and the stigma of bankruptcy. But, these days, things are very different in the world of municipal finance.

At the root of the problem is the incentive system that elected officials used to face. For decades, across the US, local leaders ran up tabs for future taxpayers; they promised pensions and other benefits for public employees that have strong legal protection. That has been a great source of patronage for elected officials: they can promise all sorts of future perks to loyal supporters (state and local workers) with very little accountability on the delivery of those promises.

Today, we are left with the legacies of this waste. The bill for promises past is now so large for some cities and towns that it is crowding out money for the most basic of services – in the case of Detroit, it could not even afford to run its traffic lights. Across many American cities, cuts to basic social services have already been so deep that they have made the communities unpleasant places.

Read the rest here.

Ms. Whitney has had strident critics for predicting defaults by 50 to 100 cities to the tune of of “$100s of billion dollars” in 2010 such as David Kotok of the Cumberland Advisors.

Nonetheless currently the unfunded state and local pension liabilities has been estimated at a huge $3.8-4 trillion. This should gobble up a huge share of state budgets in the backdrop of a highly fragile steroids dependent economy. Also, pension shortfalls increases state or muni credit risks, if expected or targeted returns are unmet.

Yet if bond vigilantes continue to unsettle the interest rate markets, and or, if the FED does “taper”, where Dr. Bernanke said last week, “If we were to tighten policy, the economy would tank”, then it wouldn’t be far fetched for Ms. Whitney’s predictions to come to fruition.