U.S. states: Running with the PIIGS

NEW YORK (Fortune) -- The term PIIGS has been coined to refer collectively to Portugal, Italy, Ireland, Greece, and Spain. Aside from being a cute acronym, the term describes the actions of these countries very aptly as they have acted "piggish" in issuing debt to support overzealous government budgets. While the American media has at times made light of these countries and their PIIGS moniker, the same mistakes are at play in creating domestic pigs.

If PIIGS refers to nations that have overspent and are now overleveraging to pay for their deficits, the United States is feeding from the same trough.

There are two key ratios used to highlight when a government is reaching the crisis zone of fiscal imbalance: the debt-to-GDP ratio and deficit-as-a-percentage-of-GDP. Historically, a debt-to-GDP of north of 90% and a deficit-as-a-percentage-of-GDP north of 10% have been the lines in the sand to watch. As governments cross these barriers, they enter the Pig Zone.

While the leaders of Greece can try to blame speculators for their fiscal issues, the reality is that hedge funds are betting against Greece based on years of the country budgeting well beyond its means. The Greek leaders have managed their nation to a debt-to-GDP ratio north of 110% and deficit-as-a-percentage-of-GDP that exceeds 12.7%. Blaming speculators may be political convenient, but it doesn't change the facts.

As we watch the Greece situation unfold, the fiscal metrics in the United States become even more concerning. According to my estimates, the United States is running a debt-to-GDP ratio of 84% and deficit-to-GDP of almost 11%.

The United States last defaulted on debt in 1933 by refusing to repay certain bonds in gold as promised. While we are not suggesting that a U.S. debt default is anywhere near imminent, the ratios outlined above are concerning and do place our federal government squarely in the Pig Zone.

Furthermore, dig into fiscal imbalances at the state level and the picture gets even worse. According to a recent study by the Pew Center, a nonpartisan think tank, there is a $1 trillion gap between $3.35 trillion in pension, health care, and other retirement obligations on state balance sheets versus the $2.35 trillion in assets to cover them. This is a massive future budgetary gap, which will have to be funded, at least partially, by debt.

So, which states are in the worst shape? In fact, an estimated 41 state pension programs are less than 10% funded. In addition, only 5% of the $587 billion liability for current and future retiree health care and other non-pension benefits is currently funded.

In fact, to deal with massive deficits, totaling approximately $290 billion, many states have tapped into their rainy day funds in fiscal 2009 and 2010 at levels not seen since the 2001 recession. Moreover, several states have dried up their funds to balance their current budgets, including Alabama, Arizona, California, Connecticut, Maine, New Jersey, Ohio, Oklahoma, and Pennsylvania.

In the table below I have highlighted the states that we believe are in the most dire straits. My research team and I looked at a few basic metrics: budget funding gap, foreclosure rate, unemployment rate, and the nature of the government. Collectively, these states had an expected funding gap of at least more than 20% in fiscal 2010. Combined with this were low projected revenues based on high unemployment rates and high rates of foreclosure, which diminish property taxes.

These six states screen negatively on all of these metrics, and five of these six states also require a supermajority to implement budget bills or tax increases. In effect, these states will have a difficult time increasing taxes to fund losses -- so the inevitable fallback is to issue more state-level debt.

Historically, according to Moody's, municipal bonds have defaulted at a rate of less than 0.1% versus corporate default rates of 9.7%, and have been considered the ultimate secure investments. That, of course, hasn't always been the case. In fact, in the 1930s municipal bonds in the United States defaulted at a rate of more than 30%.

Many municipal bond funds continue to assume historically low default rates. As we dig into state-level finances, the facts suggest a different future. Astute investors have already begun selling municipal bonds. As Warren Buffett recently stated, insuring municipal bonds "has the look of a dangerous business." It's hard to disagree.

Daryl G. Jones is the managing director of Risk Management at Hedgeye, a research firm based in New Haven, Conn. His colleague Darius Dale also contributed to this column.