The housing crash [has] not yet realized its full impact on budgets in the most vulnerable states. It's the banking crisis all over again - and it's time to stop ignoring it.

Meredith Whitney, the superstar analyst who famously forecast disaster for America's big banks before the credit crisis struck, is now warning about another looming threat: The wreckage from over-stretched state budgets.
Today, Whitney is releasing a 600-page report, colorfully entitled "The Tragedy of the Commons," that rates the financial
condition of America's 15 largest states, measured by their GDP. Whitney claims that the study is the most comprehensive, in-depth analysis of the states' murky patterns of spending, revenues and benefits programs ever assembled by the government, foundations, or another research firm.

What Whitney found reminds her of the poor disclosure and arcane accounting rules that hid the fragile condition of the banks and monoline insurers that she unmasked. "The states represent the new systemic risk to financial markets," says Whitney. "I see a lack of transparency and an abundance of complacency on the part of investors and politicians, just as we saw before the banks imploded."

The study represents a departure for Whitney, whose boutique research firm specializes in providing its clients, including hedge funds, big institutions and banks, with proprietary research on the financial condition of consumers, ranging from projections on credit card defaults to regional employment trends. So why the mega-work on the states? "It's not that my clients requested it," says Whitney. "I was just so shocked by what I was seeing that I couldn't stop. Any long-term strategic plan needs to take account of the dangerous, mostly overlooked problems in the state finances." Whitney describes the reports as "her favorite child."

The title, "The Tragedy of the Commons," comes from a parable about greedy farmers who let their sheep gobble up all the grass in a pasture, leaving the land barren and unfarmable--reflecting the spending frenzy that promises to decimate the prospects for many of America's largest, and formerly most prosperous, states.

Bigger economies, lower ratings

In the report, Whitney rates the fifteen states on four criteria, their economy, fiscal health, housing, and taxes. For each category, she assigns a rating of one, two or three for best, neutral or negative. Only two states get positive overall ratings: Texas and Virginia. Eight are either negative, or rated neutral, with a negative bias. The rub is that those are typically the states with the biggest economies: California, Ohio, New Jersey, Michigan, and Illinois (all negative) and Florida, Georgia, and New York (neutral, negative bias).

David Fuller's view This is another sad tale concerning failures of governance, resulting in self-inflicted wounds. It is a good reason to be cautious about the rate of US economic recovery over the next few years.

What does it mean for stock markets?

The answer may not be what you think.

Federal government debt, state debt and consumer debt ensure that the US central bank will keep interest rates low for as long as possible. That means, until CPI inflation eventually becomes a political liability.

Currently, the Fed is fighting deflationary risks and fears. Ben Bernanke, along with central bankers in other debt-mired economies, has more reason than ever to be a closet inflationist. When governments cannot pay back their debt through economic growth, they either default or inflate it away.

The US government will not default. It does not need to because the debt is in US dollars and the greenback remains the world's reserve currency. Instead, the Fed will continue to print money. This is a form of fiduciary default by stealth.

Low interest rates and a soft currency remain bullish for US multinational equities. Leading companies leveraged to the emerging (progressing) economies are creditors rather than debtors. With strong balance sheets they can afford to raise dividends, make share buybacks, increase capital expenditure, borrow cheaply and make takeovers.

Many investors, not least pension funds, are overweight bonds. This was a good strategy but low, deflation-discounting yields are far less attractive today. Moreover, global economic recovery, albeit slow in the West, will eventually lead to higher yields. Consequently, equities are now the more attractive investment due to their potential for earnings and dividend growth.