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Detroit to Restructure $800 Million

CHICAGO - In a deal that may mark Berkshire Hathaway Assurance Corp.'s first primary market appearance, Detroit this week will begin restructuring nearly $800 million of insured variable-rate water and sewage revenue bonds in a complex transaction forged under mounting pressure posed by the potential loss of liquidity facilities.

In its first bond transaction since late 2006, the city beginning on Thursday will remarket roughly $385 million of sewage revenue bonds in a fixed-rate mode. The mode conversion is permitted under the bonds' original covenants. The city will follow up on May 8 with the conversion of another $385 million of water revenue bonds.

The transactions come after a series of failed remarketings on the bonds that began in late February after the downgrade of the once triple-A insurer Financial Guaranty Insurance Co. that insured the original deals.

By converting to a fixed-rate mode, the city avoids the need to find and pay for liquidity on the remarketed bonds. It is a task that has proven both more difficult and expensive given the level of auction-rate and insured floating-rate restructurings flooding the market as a result of the collapse of the auction-rate market and downgrade of insurers.

The fixed-rate structure also allows Detroit to avoid expensive termination payments on its existing floating- to fixed-rate swaps attached to the original issues. The city will leave the swaps in place and bid out reverse swaps.

The reverse swaps will, in effect, hedge the existing floating-to-fixed swaps now in place. Under the new reverse swap, Detroit will pay a rate based on the Securities Industry and Financial Markets Association's index in exchange for a fixed-rate payment from its counterparties.

The two variable-rate payments, both paid by Detroit and received by the city, will be based on the same index and so will match. The two fixed-rate payments will not match perfectly, so the city is expected to incur additional interest costs of about 150 basis points for each series of bonds. The plan allows the city to spread out the added borrowing costs, whereas it would have had to come up with the termination payments up front.

It's the first time Detroit has entered into reverse, or "mirror," swaps, and it is a move that would have been "ludicrous" a year ago, according to Moody's Investors Service analyst Elizabeth Foos. "But this is a different environment with different challenges," she said. The termination payments could well have exceeded $250 million for all the existing swaps.

One of the largest regional water systems in the U.S., the Detroit Water and Sewage Department earned mixed reviews from rating agencies in advance of the upcoming transactions. Standard & Poor's upgraded the system's debt while Moody's downgraded it and Fitch Ratings affirmed its current ratings but revised its outlook to negative. All three agencies rate the credit in the single-A range.

The liquidity pressure facing the city stems from the failed remarketing of some of the bonds following FGIC's downgrade in February. The liquidity banks now hold some portion of the bonds and the purchase has triggered a 180-day deadline after which the city will be required to begin making accelerated principal payments on a quarterly basis to the banks on the bonds they hold for the next seven or 10 years, depending on the original bond documents.

Dexia Credit Local and Depfa Bank are the providers of standby purchase agreements on the various series. Depfa holds $238.5 million of sewage bonds, and $187.3 million of water bonds. Dexia did not report any purchased bonds for either sewage or water bonds, according to Moody's.

The interest rates on the bonds now held by the banks vary based primarily on a formula tied to the federal funds rate plus an index. The rates vary, but are lower than the prime borrowing rate, and so far have not proved too expensive for the city, according to sources.

The remarketing agents also hold some bonds and some remain in the hands of investors. The maximum rate paid by the city at various points following weekly remarketings since February has been 11%.

FGIC's downgrade permits the banks to issue a 30-day notice of termination of standby bond purchase agreements on outstanding bonds. If FGIC were downgraded again - to a below investment-grade rating - Detroit could face the immediate termination of its liquidity facilities, Moody's said. So far, neither Dexia nor Depfa has issued any notices of termination to the city.

"The banks haven't given Detroit notice yet because they know they're trying to remarket and terminate all agreements," Foos said.

FGIC is rated Baa3 and on review for possible downgrade by Moody's, BB by Standard & Poor's, and BBB by Fitch, both with negative outlook.

As the finance team crafted the transaction, they met with several monoline bond insurers with the hope of leaving the FGIC policy in place and bringing in a secondary insurer for additional protection. Officials considered Financial Security Assurance - which insures a remaining piece of the water and sewer bonds - but the insurer backed off because of its heavy coverage of much of the city's outstanding debt.

Only Berkshire Hathaway was interested in acting as a secondary insurer with FGIC, according to a source. "They didn't have the same idea about FGIC being in place on the bonds as the other insurers had," he said. "The Berkshire insurance really gilds the lily [on the bonds]." It will mark the first time that BHAC will act as insurer on a primary market transaction, officials said.

Berkshire carries a AAA rating from Standard & Poor's and last week it earned a primary market Aaa from Moody's, which had previously assigned the new insurer top marks as a secondary insurer.

The restructuring that begins this week is divided into three series: $122.1 million of senior-lien bonds, $138.3 million of second-lien revenue bonds, and $124.4 million of second-lien revenue bonds.

The water bonds are divided into two series: $195 million of senior-lien revenue bonds and $190.6 million of second-lien bonds.

UBS SecuritiesLLC and Loop Capital Markets LLC are co-senior underwriters on the sewer bond transaction, with Fifth Third Securities, M.R. Beal & Co., and Raymond James & Associates rounding out the underwriting team. Lewis & Munday is bond counsel, and Robert W. Baird & Co. and Phoenix Capital Partners are co-financial advisers on both water and sewer transactions.

The underwriting team on the water deal was not yet available.

The Detroit Water and Sewerage Department serves nearly half of Michigan, making it one of the largest regional water systems in the country. It has a total of $2.27 billion of outstanding water bonds and $2.6 billion of outstanding sewage debt. Taken together, roughly $800 million of the water and sewer bonds are variable-rate debt insured by FGIC, while a smaller piece of the variable-rate debt is insured by FSA. Officials do not expect to remarket the FSA debt.

Of the $2.27 billion in water bonds, roughly $505 million is insured variable-rate debt obligations, of which 75% is insured by FGIC and is set to be remarketed.

Of the $2.6 billion in sewer debt, $693 million is insured VRDOs, of which 56% is insured by FGIC and will be restructured.

While both Standard & Poor's and Moody's noted the water system's strengths in their reports, Moody's downgrade and warning of a possible additional downgrade stems primarily from risks to the system's liquidity.

Moody's cut the senior-lien water-sewer bonds to A2 from A1, and the second-lien water-sewer bonds to A3 from A2. Moody's also placed the debt on watch list for further downgrade.

Noting the system's large service area, ample water supply, and improvements under new management, Standard & Poor's upgraded its underlying rating on the senior-lien bonds to A-plus from A, and upgraded its underling rating on the second-lien bonds to A from A-minus.

Fitch assigned an A-plus to the senior-lien bonds and A to the second-lien bonds and revised its outlook to negative from stable outlook on all the debt. It cited in part the system's problem with unpaid and late bills, which could worsen under a weakened economy, said Fitch analyst Melanie Shaker.

In addition to the upcoming remarketings, the system plans to begin issuing new-money bonds later this year as part of its four-year, $1.5 billion capital improvement plan, officials said. The plan will largely rely on borrowing.

The remarketing is the first bond transaction for Detroit since a refunding issue in November 2006. The city has been forced to delay some issues as it has struggled to release its long-delayed annual audits.

In February, officials finally released the city's 2006 audit, and promised Michigan - which began withholding some of its state revenue aid - that Detroit would push forward to release its 2007 as soon as possible. Meanwhile, the 2008 audit is expected to include the city's actuarially accrued cost for providing health care benefits to current and future retirees.

 

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