June 6, 2011: 1:44 PM ETFORTUNE -- Meredith Whitney is issuing a fresh warning to mutual funds, banks, and politicians: The state of state finances is far worse than what you think, or at least than what you've been willing to tell the investors and taxpayers who will eventually carry the burden. In a new report released today to her clients, Whitney summons what appears to be the most comprehensive set of data ever assembled on state budgets and debt.
Her conclusion is that the future deficits that need to be closed, either by new taxes or draconian cuts in social services, are far bigger than the official numbers show, and that debt levels, when all liabilities are counted, vastly exceed the official estimates.
Late last year on 60 Minutes, Whitney predicted hundreds of billions in defaults on municipal bonds in the next five years. That controversial call was widely condemned, especially on Wall Street, where the muni market is an enormous profit spinner.
Now, Whitney tells Fortune she never meant to make more than a general forecast. "I never intended on framing the scale of defaults as a precise estimate, but I continue to believe that degree of municipal defaults will be borne out over the cycle. I meant to point out that the state debt problem is a massive headwind for the U.S. economy, second in importance only to housing."
Whether you agree with it or not -- and she's still getting little support from rating agencies or anywhere else -- the numbers she's assembled, and the risks they pose, are daunting.
Whitney's latest report is even more thorough than last year's analysis that started the uproar. It covers 25 of the largest states, adding ten new ones to the list, including Arizona, Nevada, Connecticut, and Wisconsin. The problem starts with spending. Since 2003, state governments have raised annual outlays from $1.5 trillion to almost $2.2 trillion, or $700 billion, yet tax receipts have risen only $400 billion or $300 billion less, to $1.4 trillion. In fact, spending kept surging all during the recession, while income from sales, income and corporate taxes went totally flat in 2007.
Three big problems, no solutionBut 46 states are obligated to balance their budgets each year. So how are they bringing receipts in line with spending when taxes fall 36% short of revenue? And remember, this gap is growing despite big tax increases that are becoming more and more difficult. The states are getting that extra money from three sources. First, the federal government enormously increased aid to the states under the stimulus or American Recovery and Reinvestment Act. Since 2009, the ARRA has delivered $480 billion in grants and contracts, padding over one-third of their combined deficits. But the last stimulus dollars expire this month.
Even with a historic increase in federal assistance, the states have relied on two additional measures to plug the remainder of the shortfall -- measures that will be harder and harder to repeat. The states tapped "rainy day" funds or surpluses reserved for emergencies. Their governments used $9 billion of that cash in 2010, with Connecticut totally exhausting its $1.4 billion in reserves, and Pennsylvania tapping its emergency savings for $755 million.
Second, the states have immensely increased their issuance of General Obligation bonds that fund what corporations strive to avoid -- paying operating expenses with long-term debt. Those securities are backed exclusively by state tax revenue. In 2000, the states issued $67 billion in GO securities; last year, they raised $148 billion from those bonds. While Whitney acknowledges that this class of securities is unlikely to see defaults, they still place a huge burden on the future. The reason: Fixed interest expenses are absorbing a bigger and bigger share of state budgets, leaving a shrinking portion for everything else.
Today, debt service absorbs half of Nevada's budget, and 40% of Michigan's. In Arizona, California, Connecticut, Ohio and Illinois, the share now exceeds 20%.
The third and biggest problem, pension costs, both increases current cash expenses and artificially understates what the states should be spending today. Even by putting the minimum into their pension funds, they're still crowding out spending for everything else because the costs are rising so fast. Hence, it ensures that future tax increases and spending cuts will be far greater than advertised. The states are systematically underfunding their pensions. Today, they cover 77% of their future liabilities versus 103% in 2000. If they fully paid their annual pension costs, the states would need to increase spending by over $700 billion a year, or over 40% of their current outlays.
And those figures don't include future spending on health care costs, falling into a little-known category called OPEB or Other Post Employment Benefits. Most states simply pay these OPEB costs directly from revenues. No actual income-generating funds, accumulated for the future, back them in most states. New Jersey, New York, Connecticut and Illinois are all pay-as-you go states with totally unfunded OPEB liabilities. As those costs inevitably swell, they will apply even more pressure to state budgets.
Meredith Whitney: State finances are worse than estimated - The Term Sheet: Fortune's deals blog Term Sheet