Municipal bonds aren't boring anymore. Long the refuge of conservative investors and retirees seeking steady, tax-free returns and a stable place to park their cash, muni and state debt is now viewed increasingly as a gamble. Cable news shows are full of speculation that Washington's next bailout will be to shore up the finances of deficit-racked states and cities struggling under ever-higher burdens of public pensions and Medicaid obligations.

Fears of defaults by state and local governments have been dogging the sector for more than two years, thanks to the bankruptcy of Vallejo, Calif., and the near insolvencies of Jefferson County, Ala., Harrisburg, Pa., and others. Then the market was cast into near panic in December when CBS' "60 Minutes" aired an interview with telegenic analyst Meredith Whitney. Famous for her bearish calls on banks, Whitney predicted there would be 50 to 100 sizable state and municipal defaults in the near future. The coming collapse, she said, will affect debt worth "hundreds of billions" of dollars and likely lead to immense pressure on Washington to bail out the burdened governments and their investors. Her comments sparked a monthlong muni selloff, with investors yanking $4 billion out of the market through mid-January. Stability has slowly returned, but wariness lingers.

While muni experts panned her prognostication as overly dire, the fact remains that state and city finances are a mess. And though defaults on local government debt have been rare, a handful of jurisdictions may have to make draconian moves to stay current on debt obligations. The menu includes service cuts and tax hikes. Nevertheless, it's wrong to paint the situation as an immediate crisis. Most current-year budget problems are being addressed with spending cuts and tax hikes. The longer-term fiscal wreck presented by pension and healthcare burdens can be addressed over the next decade. But, as is so often the case, lawmakers are hyping the situation to pursue initiatives that wouldn't get traction without the presence of a crisis.

Whitney's prediction certainly caught Washington's attention. At the same time, city and state officials were prowling congressional offices talking up various ways the federal government could help, with suggestions varying from new stimulus to relief on Medicaid and unemployment insurance. The new Republican majority in the House has seized on the issue, warning that financially profligate local and state officials are kidding themselves if they think their turn for a bailout has arrived. "The era of the bailout is over," Rep. Patrick McHenry, R-N.C., chairman of the House Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, said at a Feb. 9 hearing. The GOP has also used the issue to attack one of their chief targets -- public-sector unions, which they say have used collective-bargaining muscle to extract outsized wage, pension and health benefits from taxpayers, whose private-sector jobs often provide much less generous packages.

"It seems to me that public-sector and private-sector employees are living in two separate economies," McHenry said, arguing that public workers make on average $14 more per hour in wages and benefits than private counterparts. Some conservative pundits have called for outlawing public-employee collective-bargaining rights. Many also call for an end to defined-benefit pensions, an open-ended obligation companies began abandoning years ago.

On the same day as the hearing, Rep. Devin Nunes, R-Calif., and Sen. Richard Burr, R-N.C., introduced the Public Employee Pension Transparency Act. The bill would implement uniform reporting standards for public-employee pension funds but would not dictate how the pensions are funded. It would, however, bar a federal bailout of state and local government pensions. "It is time to open the books," Nunes said in a statement. "Once we enact this bill, retirees, government workers, policy makers, and most importantly the people who are paying the bills, can make up their own minds about the soundness of public pensions."

Potential Republican presidential candidate Newt Gingrich and former Florida Gov. Jeb Bush seized upon the uproar to call for letting states declare bankruptcy, an option already open to cities. The option excites them because it might allow states to break pension requirements. They complained that California alone will pay pensions of $100,000 or more this year to 12,000 former government workers.

David Skeel, corporate law professor at the University of Pennsylvania School of Law, told McHenry's subcommittee that allowing states to declare bankruptcy would allow them to restructure their obligations -- including pensions and bonds -- at the same time. "It
brings everybody to the table. Not just one or two constituencies would be asked to sacrifice."

Democrats also appear determined, as the Washington cliché has it, not to let a crisis go to waste. Recognizing that a new round of stimulus or a direct handout to states is a political impossibility following the GOP's House takeover, President Obama on Feb. 14 proposed a slightly less direct approach. His budget would give employers an extra two years before higher unemployment compensation taxes kicked in. States also would get a two-year reprieve before they have to start repaying loans they took out to cover the added unemployment burden created by the downturn.

Amid the debate, there's no disagreement about the sorry conditions of states' books. Almost entirely because of the economic downturn, states are predicting operating deficits totaling $125 billion in 2012, according to the Center for Budget and Policy Priorities. Although revenues are slowly recovering from the downturn's nadir, they remain 12% below prerecession levels.

Longer term, states face pension shortfalls that vary from $1 trillion -- if you believe their forecasts -- to $3.5 trillion -- if you accept the numbers of more skeptical economists.

Whitney has painted the combination of operating deficits and pension underfunding as one that will inevitably lead to major defaults. But even muni debt analysts critical of the government do not predict the pension issue will come to a head in the next few years.

According to a study by Northwestern University associate professor Joshua Rauh, at least 31 states will eventually face pension shortfalls. Eight will run out of assets by 2020. Underfunding by Illinois is the most pressing issue. That state, Rauh predicts, will run out of pension assets in 2018, at which time it will have to kick in $11 billion annually to meet its obligations. That's hardly good news to Illinois taxpayers, whom Gov. Pat Quinn just hit with a 66% increase in state income taxes to cover the current gap in the operating budget. Rauh notes that Illinois' pension assumptions are overly optimistic. More conservative -- and in his view, reasonable -- assumptions bring the crisis to a head sooner, but still years away.

According to Rauh's study, New Jersey faces a similar situation: It will need $10 billion annually beginning in 2020. Ohio, which will require $13.8 billion beginning in 2031, is in the same boat.

To stabilize pensions, Rauh has recommended states be allowed to issue tax-subsidized pension funding bonds for the next 15 years if they implement specific pension reforms. To get the subsidy, states must agree to close defined-benefit plans to the 1 million new workers who take state jobs every year, and provide new hires defined-contribution plans similar to the federal Thrift Savings Program, as well as guaranteed access to Social Security. Only a quarter of public workers contribute to Social Security. Bringing them into the system would add a further $175 billion to the program, he says.

The cost for the pension security bonds would be about $250 billion. Incorporating the offsetting Social Security gain, he says the subsidy's final cost to the federal government would be $75 billion, far less than the $1 trillion minimum that would be needed to right the current local pension system.

The notion of switching new pensions from defined-benefit to defined-contribution plans is gaining traction among politicians. Guaranteed-benefit plans offer retirees a fixed paycheck regardless of how fund assets have performed or whether employers have fully funded them. Defined-contribution plans require employers to make annual payments to retirement funds, and the payout is based on how the funds performed over the workers' careers.

Nicole Gelinas, a fellow at the Manhattan Institute, told McHenry's committee that governments cannot break obligations to current workers but should restructure pensions for new employees. She favors defined-contribution plans. The federal government, however, should let states work out the restructuring on their own. "States already have tools to deal with these things themselves. States can change their laws that govern pensions. States can change their laws that govern contracts, healthcare benefits. They do not need to look for Congress to do it for them." She did say that the federal government could assist states by lessening Medicaid obligations.

Eileen Norcross, research fellow at George Mason University's Mercatus Center, told the committee that there is one thing Congress should do: Insist that states make more realistic assumptions about portfolio rates of return. Both contributions and benefit promises should be based on those numbers. On average, states have assumed they can make 8% annual returns year after year. Instead, she said, economists believe 4% is a more appropriate assumption.

"The circular logic of government pension accounting standards has had several consequences," Norcross said. "It has led to undervaluing of pension promises and the amount necessary to fund the promise. Politicians ... in the 1990s often boosted benefit formulas because plans were overvalued on paper. Plans have been encouraged to embrace more investment risk, including increasing their risk exposure after the recent market downturn to make up for losses."

Representatives of state and municipal employees say the attack on pensions is a canard. Steven Kreisberg, collective bargaining director for the American Federation of State, County and Municipal Employees, argues that the notion that government budgets are under stress because of pensions is "the biggest myth out there." He says, "State and local governments are spending 3% of their budgets on pensions. If you say that's what's going to drive state budgets off the cliff, I'm going to debate you."

By far the biggest expenditures are health and education for states and public safety for municipalities. Nearly all have made cuts in those areas since the recession. "States are spending less," he says. "It's not spending that's the problem; it's the recession."

The pension focus is really just a way to attack unions, Kreisberg says. He notes that the average government union worker makes just over $40,000 and will be entitled to a pension of roughly $19,000 a year. "We need to separate the political agenda from the real economics of pension plans. These are real people being hurt -- librarians, police officers and firemen. They're going after the wrong guys."

In states with dire pension shortfalls, Kreisberg says the culprit has been chronic underfunding. "New Jersey got into hot water after 17 years of neglect that began with Gov. Christine Todd Whitman. In Illinois there has been a 30-year history of underfunding."

The call for allowing state bankruptcy isn't a serious proposal, but simply "a political ploy" to divert attention from tax cuts Republicans want to enact. "They're trying to hype the notion that government is collapsing around us. Bankruptcy was never a serious policy proposal. No governor has wanted it." He notes that in municipalities where bankruptcy has been declared or seriously considered, the town's problems were caused not by pensions but by "misguided capital projects" such as Jefferson County's $3 billion water treatment plant.

What's more, he says, bankruptcy doesn't provide a legal avenue for addressing pensions. "Bankruptcy does not allow you to unwind pension obligations. They're long-term obligations and not a factor in immediate liquidity problems. What's going to happen in order to make pensions whole, bankrupt towns might have to lay people off."

Kreisberg criticizes Nunes' bill on transparency too. "These guys must have read a lot of George Orwell as kids. They would essentially be creating an accounting regime for pension plans that no one else uses. The plan would require states to value pensions as if they were to be terminated immediately."

Kreisberg has a more favorable view of a separate effort under way at the Government Accounting Standards Board to create uniform reporting standards. GASB is also examining actuarial assumptions for government contributions and promised benefits. Neither Norcross nor Gelinas would offer an opinion of GASB's plan until actuarial assumptions are presented.

"I think real trouble is brewing," says Valerie Roberts, Jones Day's head of the muni bond tax practice. "I don't think it's quite imminent, but the recent debate has been a good wake-up call. Many governmental pension funds currently claim they are well funded. However, I think many will find they are not if new GASB standards are adopted."

Iris Lav, senior adviser to the Center on Budget and Policy Priorities, agrees with Kreisberg that no federal actions need to be taken. "Most states are not in crisis," she says. "There's no need for federal intervention in this area."

States can -- and are -- dealing with short-term funding gaps caused by recession. She agrees that cuts to education and police and fire departments are painful. But they are necessary and for the most part being made.

She opposes lowering pensions' expected investment returns because it doesn't reflect the likely returns an appropriately mixed portfolio will provide. Longer-term shortfalls can be addressed by boosting state contributions. States contribute, on average, 3.8% of their budget to pensions. The gap could be closed, she says, by increasing that to a manageable 5%. Defaults will likely be limited to "some sewer districts and some revenue bonds," she says. "I don't think we're going to have a major default crisis."

See related story, "The world wonders: Can states go bankrupt?"