The U.S. Might be the New EU

Meredith Whitney, founder and CEO of the Meredith Whitney Advisory Group, appeared on CNBC's Squawk Box Wednesday morning. In her appearance, she reiterated her call for municipality defaults.

She stated that she anticipated some form of restructuring in the municipal market, as local politicians were more concerned with taking care of their constituents than in paying their bond holders. Whitney acknowledged that the bond markets have not reflected her economic thesis, but stated that most state governors agreed with her assessment. She explained that states will need to sell their assets to raise cash.

On Tuesday, the Chairman of the Federal Reserve, Ben Bernanke, spoke to a group of bankers. In the subsequent question and answer session, Jamie Dimon—the CEO of JP Morgan Chase & Co—asked Bernanke about his opinion over new banking regulations that may be forthcoming. Dimon expressed concern that the regulations may be unnecessary and could have negative consequences.

Dimon's point about negative regulatory consequences did not phase Whitney. "Regulatory issues are not here and now. They are getting worked out," she stated. "The Fed is delaying a lot of decisions. This will happen over the next several years."

Whitney pointed to the banking systems of foreign countries to illustrate her point, "Look at Brazil and Turkey. They have much higher capital requirements on their banks, and their banks are booming."

When asked specifically about the Dodd-Frank legislation, Whitney characterized it as having been "hastily thrown together." She predicted that it would ultimately be delayed and watered-down.

In terms of the general market, Whitney was not willing to give a broad assessment, instead focusing her analysis on the financials. Whitney spoke about what she called the "de-banking" of the consumer: banks do not want to lend that consumers who wish to borrow, and the consumers banks want to lend to do not want to borrow. Whitney claimed that the headwinds affecting the U.S. economy because of the banking system were worse than the headwinds generated by the disasters in Japan.

In regards to the potential of state bailouts, Whitney questioned whether the political will was there to accomplish them. For example, she raised the question: would a citizen of Indiana want to bailout the state of Nevada? Should this scenario play out, it will look interestingly similar to the debt crisis facing the European Union.

If Whitney's assessment is true, it is certainly bearish for the municipal bond market.

Action Items

Bullish: Traders who believe that Whitney's views are accurate might want to consider the following trades:

• Short iShares S&P National AMTFr Municipal Bond Fund (NYSE: MUB). MUB is an ETF that tracks the broader municipal bond market and may enter a bear-market if there are mass municipal defaults.
• PowerShares DB US Dollar Bullish Index (NYSE: UUP) is a long play on the dollar. A mass municipal default may shock the financial system similar to the crisis in 2008. The dollar rallied sharply following that event, and might do so again if there is a further municipal financial shock.

Bearish: Traders who believe that Whitney is wrong, or that the federal government would bailout the states to prevent municipal defaults,may consider taking positions in the following:

• PowerShares DB US Dollar Bearish Index (NYSE: UDN). If the federal government bails out local municipalities, it may be bearish for the U.S. dollar, as federal debt may increase at the cost of bailing out the municipalities.
• Market Vectors High-Yield Muni ETF (NYSE: HYD) is an ETF which focuses on low-grade municipal bonds. If the municipal bond market tanks, HYD might plummet, but if Whitney is wrong, HYD could rally sharply as investors have their confidence in municipal bonds restored.

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