Vulture capitalists—investors who profit off of financially distressed companies by stripping assets, laying off workers, and loading up debt—killed the Hostess Twinkie last summer to make a buck, and they may soon be trying to kill local government services around the country for the same reason.

Flush with cash as the stock market soars to record highs, yet with few investment opportunities to their liking in the still-hurting private sector, vulture capitalists circling high in the financial sky believe they have spied their next set of targets: fiscally struggling cities and counties like Detroit, Michigan; Stockton, California; San Bernardino, California; and Jefferson County, Alabama, where Birmingham is located.

It has already begun in Birmingham, where several hedge funds—including Monarch Alternative Capital, which was a major player in the Hostess bankruptcy and Stone Lion Capital, which was involved in the bankruptcy of Eastman Kodak—have bought more than $600 million of Jefferson County debt. Under pressure after filing the most expensive municipal bankruptcy ever in the US in November 2011, Jefferson County has since cut expenses and laid off more than 700 county workers.

Detroit, with $8.6 billion in long-term debt, is the big target, but Republican Gov. Rick Snyder appointed financial czar Kevyn Orr barely two months ago, so the going is still early. Earlier this year, however, the sale of a $25 million block of Detroit pension certificates at about 66 cents on the dollar suggested hedge fund involvement, according to Matt Fabian of the Municipal Market Advisors research firm.

Confirming that interest is running high, Alan Mintz, the founder of Stone Lion Capital, said that “Detroit is something we as well as other funds have looked at,” while Marti Kopacz of Brant Point Advisors gushed that “Everyone is looking for ways into Detroit. It's new and unique.”

How do these vulture capitalists expect to make money on these investments, especially in light of the political constraints involved in local government and the need to provide basic services like police, firefighting and trash collection? Several strategies suggest themselves, including cutting local budgets, selling off assets, lending, and municipal bonds. The question will then turn on how far local government services can be cut.

Matt Fabian explained that one bond strategy would be for hedge funds to negotiate repayment on their bonds at a discounted rate, say 80 cents on the dollar, which would make hedge fund investors rich, save Detroit money, but disadvantage investors who bought the same debt at par. Long term, however, Fabian notes that a discounted repayment of great size could send municipal debt prices even lower, creating distress in the bond market and harming cities that have issued debt. That process could lead to a cascade effect, as additional local governments find it increasingly difficult to issue bonds, thus creating a growing supply of financially distressed localities supposedly in need of private financing.

-Matt Bewig

To Learn More:

Analysis: Hedge funds in search of distress take a look at Detroit (by Tom Hals, Reuters)

Michigan Gov. Snyder Moves to Supersede Detroit’s Elected Government (by Matt Bewig, AllGov)

Stockton Wasn’t Lying—It Really Is Bankrupt (by Ken Broder, AllGov California)

State Says Bankrupt San Bernardino Stashed $528.9 Million in Redevelopment Funds (by Ken Broder, AllGov California)