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Meredith Whitney Sounds Alarm on Municipal-Bond Defaults

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As 2010 comes to a close with what looks to be somewhere around a 14% return for the S&P 500, a pervasive sense of bullishness on Wall Street is palpable.

This is most likely a result of the fact that virtually every closely followed benchmark is at its 52-week high: the Dow Industrials; Barron’s 400; Nasdaq Composite and Nasdaq 100; the S&P 500, S&P mid-cap 400 and S&P small-cap 600; the Russell 2000; NYSE; ValueLine; biotech; oil. Gold is just off its 52-week high, but not doing too shabbily: it’s been a good 52 weeks.

And as for 2011, investment strategists at Wall Street’s 11 biggest firms remain upbeat, their average projection for the S&P 500 being 1,374 — which would produce the biggest three-year rally since 1997-2000, according to Bloomberg, which conducts these annual surveys.

Into the current feel-good Santa Claus rally comes bank analyst Meredith Whitney in the role of Scrooge, dampening current sentiment as so much humbug.

In an interview on CBS’ “60 Minutes” program Sunday night, Whitney (left) boldly predicted a muni finance crisis of epic proportions, with 50 to 100 major defaults amounting to hundreds of billions of dollars in losses. “I think next to housing this is the single most important issue in the United States and certainly the largest threat to the U.S. economy,”she told interviewer Steve Kroft.

The gist of the problem is that states have spent, borrowed and promised more than they have or can collect. Illinois for example spends twice as much as it collects in taxes; California is already spending more on employee pensions than on its universities, and those obligations will only increase as an aging public sector workforce retires to what actuaries expect to be increasingly long lives.

Ms. Whitney was unavailable for comment, but in a 600-page report on the 15 largest states that Whitney released three months ago, the New York-based bank analyst painted a grim picture of falling municipal dominoes. Cities receive a third of their revenue from states facing major budgetary shortfalls, and the Obama stimulus has helped the states make up those shortfalls in the past two years.

When that money disappears in 2011 — and the increasingly Republican make up of Congress assures that it will — the states will have to cut off dependent cities among other benefactors of their largesse.

Whitney rose to notoriety when she correctly predicted impending disaster for America’s banks before the credit crisis in 2007.

Bloomberg columnist Joe Mysak described Whitney’s hundreds of billions in muni default claims as “in the realm of the fabulous.” in a report on Wednesday. He thinks $5 billion to $10 billion is more like it.

Still, one has to wonder. Orange County, California’s infamous default on a $110 million bond issue in December 1994 sent shock waves through the bond markets. Were Los Angeles, San Diego and Oakland, Calif., — joined by Miami, Houston and other shaky cities — to default in any kind of proximity, the vaster scale of the crisis might cast a long shadow over Wall Street’s current optimistic expectations.