The housing crash 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).

The full rankings :

1. California

2. New Jersey, Illinois, Ohio (tie)

3. Michigan

4. Georgia

5. New York

6. Florida

1. Texas

2. Virginia

3. Washington

4. North Carolina

Neutral states. Pennsylvania, Maryland, Massachusetts

Put simply, the study warns that the giant gap between states’ spending and their tax revenues, estimated at $192 billion or 27% of their total budgets for the 2010 fiscal year, presents two dangers that investors are seriously underestimating. First, municipalities could start defaulting on their bonds guaranteed by the cities and towns themselves, an exceedingly rare event over the past three, mostly prosperous, decades.

“People keep saying it can’t happen, just as they said national housing prices could never go down,” says Whitney. “Now, it’s a real danger.”

The reason: the municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won’t have the funds to make their interest payments. “It has to happen,” says Whitney. “The states will secure their own shortfalls, and leave the cities to fend for themselves.” It’s all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities.

Housing fallout continues

Second, Whitney sees the budget shortfalls as a far stronger leash on both employment growth and overall expansion than investors realize. The common thread between the banking and looming state financial crises, she says, is housing. “The entire financial system was over-leveraged to real estate,” says Whitney. “So were the states.”

During the boom years from 2000 to 2008, the states that grew the fastest were the ones where housing prices grew fastest, and where construction flourished, including California, Florida, New York, and New Jersey. In Florida, almost 30% of income growth came from real estate, an astoundingly high figure. Tax revenues soared during the real estate frenzy, and spending soared along with them. Now, revenues have collapsed with housing prices, and spending is proving far stickier. The legacy: Today’s gigantic deficits.

Then, as housing prices fell, the states that grew the fastest and outperformed in the strong years, are now posting the worst economic performance––for the obvious reasons that they face the biggest mortgage delinquency and foreclosure rates, as well as high unemployment due to the collapse in construction and mortgage lending. The “haves,” says Whitney, have suddenly evolved into the “have-nots.”

The problem is that the states that benefited disproportionately from housing are generally the biggest economies, so their woes have become a deadweight on overall economic growth. “Other states such as Nebraska, even with larger ones like Texas, aren’t large enough in total to offset the weak growth in the states that depended on real estate,” says Whitney.

What investors are missing, says Whitney, is that growth in those states is destined to remain feeble because of the drastic measures needed to redeem their finances. By law, almost all states are required to balance their budgets. Right now, the Obama stimulus package is making up over $60 billion of the $192 billion shortfall for fiscal 2010. But that money is slated to disappear next year. States are already raising taxes, or planning to voters in Washington will soon vote on a referendum to levy an income tax.

The biggest source of funds to fill the still-giant gaps is especially worrisome: Raiding pension and healthcare funds. States from California to New York are shifting contributions needed to pay workers’ benefits in the future toward funding current expenses.

The housing collapse will leave a different legacy by forcing big tax increases, and cutbacks in benefits including a rise in retirement ages. Millionaires who provide a huge share of the revenues will leave the high tax states, leaving the poor who need most of the services.

“The scary thing,” says Whitney, “is that no one wants to talk about it. When you get the data and mechanics together the situation is as basic as it was for banks or consumers.” “The Tragedy of the Commons” should get people talking, and the daunting scale of the numbers should get them outraged.