02/08/2011 02:32 pm ET | Updated May 25, 2011

Why Meredith Whitney's Muni Prediction Doesn't Add Up

Banking analyst Meredith Whitney has ignited a firestorm of criticism from municipal bond analysts and business commentators (including myself on these pages) over her prediction that the 2011 municipal-bond market would implode at 2008 financial crisis levels. Her statement, made on 60 Minutes and later on CNBC, that the muni market will experience 50 to 100 large defaults representing hundreds of billions of dollars in losses over the next year caused investors to flee municipals in record numbers, even as just about anyone who knows the municipal bond market said that as bad as things are among state and local governments in terms of their budgets, the prediction is highly improbable.

Just how improbable? Consider the following:

Whitney made her prediction on December 19, 2010, nearly 6 weeks ago, and the market has experienced a total of one default, totaling just $6 million, according to Lebenthal & Co.

Now consider this: The market would need an average of 2.15 defaults each week for them to reach 100 by December 19, 2011, $4.3 billion a week to reach her $200 billion default level -- the lower end of her prediction of "hundreds of billions." Not only that, if all 50 top cities went into default on all of their debt it would add up to just $83 billion, according to Lebanthal.

These numbers shouldn't be taken as a reason to ignore the severe shortfalls in revenues flowing into municipal budgets that are used to pay debt service on municipal bonds. Also, many tax exempt bonds aren't even issued by states or cities, but are issued by companies for public projects that qualify for the same tax-exempt status as municipal bonds, so they are even more risky.

But a little perspective is in order, particularly if your a muni investor and you want to know whether you should have joined the stampede for the exits. Municipals have historically been among the safest investments (very low default rates) because cities and states have some leverage when revenues decline: they can increase taxes or cut the size of their budgets.

Times are of course changing for the worse. Large states and cities can't simply impose massive tax rates on companies and wealthy individuals any longer to pay for the welfare state of entitlements offered in places like New York and New Jersey: rich people and businesses will simply move to lower-taxed states like Texas as they have been doing.

It also difficult just to cut expenses by slashing public-workers from state and city payrolls, or their guaranteed benefits and pensions because the voting base in many fiscally challenged cities and states particularly in the northeast is comprised of substantial numbers of municipal workers.

But states and cities have faced these issues before and have managed to survive without defaulting on their debt (states cant legally declare bankruptcy) or filing the municipal equivalent of Chapter 11. At the moment, New York Governor Andrew Cuomo is demonstrating that even liberals have been mugged by the reality that taxes can't go up anymore in New York or else there won't be anymore people left to pay them. His budget calls for massive cuts, and he says he willing to take on the unions to make it work.

The best advice I've heard from anyone came from a municipal bond analyst friend of mine who said investors shouldn't panic just yet. Wait to see if Cuomo -- or New Jersey governor Chris Christie -- doesn't wimp out and actually succeeds in pushing through cuts without business-killing taxes.

And at least for the moment, and possibly longer, ignore Meredith Whitney.