Regional News

Detroit Takes the Plunge

CHICAGO - Detroit today will begin to remarket $120 million of variable-rate, A-rated water revenue debt into a fixed-rate structure - the first time the city has entered the market since all three rating agencies downgraded its general obligation debt into junk-bond territory.

The city plans to remarket another $300 million of variable-rate sewer debt into fixed-rate debt within the next two weeks.

The fixed-rate mode will allow Detroit to terminate its liquidity provider - the downgraded Depfa Bank plc - and avoid expensive termination payments on its existing floating-to-fixed rate swaps. As part of the conversion, the city will leave the swaps in place and bid out reverse swaps.

Most of the bonds to be remarketed are bank bonds, and the city enters the market under a certain amount of liquidity pressure. It must remarket the bonds before April 1 or face the start of an accelerated five-year amoritization.

The transactions come a few weeks after the city released its long-delayed 2007 financial audit. Detroit has been chronically late in filing its annual financial information - a fact that rating analysts noted in their respective downgrades - and is currently nearly three months late in filing its 2008 audit. The city's new administration is reportedly taking steps toward more timely release of financial reports.

On the water debt transaction, Siebert Brandford Shank & Co. is senior manager. Goldman, Sachs & Co. is senior manager on the sewer transaction. Lewis & Munday is bond counsel.

The city expects to remarket the sewer bonds before the end of the month, according to a city source.

The Detroit Water and Sewerage Department serves nearly half of Michigan, making it one of the largest regional water systems in the country. It remains somewhat isolated from the rest of Detroit's fiscal woes. The system has a total of $2.27 billion of outstanding water bonds and $2.6 billion of outstanding sewage debt.

The upcoming remarketings come about a year after the city undertook a similar transaction, restructuring about $800 million of insured variable-rate water and sewer debt into fixed-rate debt. Both transactions were prompted by downgraded bond insurers, failed remarketings, and liquidity pressures.

Both transactions also feature reverse swaps that allow the city to avoid expensive swap termination payments and offset existing floating-to-fixed rate swaps on the debt.

While last year Detroit dropped the downgraded Financial Guaranty Insurance Co. as part of the conversion, this time around it opted to keep Financial Security Assurance Inc. despite the insurer's loss of its Aaa rating from Moody's Investors Service.

After the upcoming transactions, the system will no longer have any variable-rate debt, though Fitch Ratings noted that $380 million of its fixed-rate debt has been effectively converted to variable rate through fixed-to-floating rate swap contracts.

Prior to the remarketing, Fitch affirmed its A rating on the second-lien debt and its A-plus rating on the senior-lien debt. Its outlook is negative on all the system's debt. Moody's rates the system's senior-lien water and sewer debt A2 and its second-lien debt A3, and keeps the debt on watch list for further downgrade. Standard & Poor's rates the system's senior-lien bonds A-plus and the second-lien bonds A.

In connection with the remarketing of the second-lien water debt, the city will enter into a fixed-to-floating interest rate swap, or a "mirror swap," effective on the conversion date. The mirror swap is designed to offset the existing floating-to-fixed-rate swap related to the bonds.

Under the mirror swap, the city will receive a fixed-rate from the swap provider and pay a floating-rate based on the Securities Industry and Financial Markets Association's index to the swap provider. Under the existing swap, Detroit currently pays a fixed rate to the swap provider and receives a floating rate.

The two swaps are expected to "completely offset each other," according to bond documents. "The city will be left with a net fixed-rate payment to the swap provider which equals the difference between the fixed-rate payment made by the city on the existing swap and the fixed-rate receipt of the city on the mirror swap."

Today is the first time Detroit has entered the market since it was hit with a trio of downgrades on its GO debt and outstanding certificates of participation from all three rating agencies earlier this year. While credit analysts said the water system is generally isolated from some of the city's fiscal woes, some investors said buyers may still link the credits.

"Detroit is on its knees right now," said Matt Dalton, chief executive officer of White Plains, N.Y.-based Belle Haven Investments. "It's obviously going to have to be priced very attractively. Right now the Jefferson County, Ala., water and sewer debt is on everyone's mind, which, if you're an investor and you're thinking of Jefferson County and then Detroit, it's a double downer."

Outside of Detroit's problems, Michigan's economy could also scare some investors, according to Dalton. "People want to stay away from Michigan right now." he said. "They associate the whole state with the auto industry, then to sell the nastiest part of the state - it makes it doubly tough."

Dalton added that despite FSA's downgrade, the insurance could make the bonds somewhat more attractive.

"That'll definitely help," he said. "Nobody wants to give anything for insurance right now, but it's still worth something."

Because Detroit has been consistently late releasing its annual audits - officials released its 2007 audit Feb. 27, 14 months late, and is now nearly three months overdue with its 2008 audit - it needs state approval before entering the bond market.

Because of the late audits, some might raise questions over whether underwriters of Detroit's disclosures are in violation of Securities and Exchange Commission financial reporting rules. Not so, said Kevin Smith, a principal at Miller, Canfield, Paddock and Stone PLC, which is acting as underwriter's counsel for Siebert on the water transaction.

While chronically late with its annual financial audits, the city has been up to date in filing various material event notices and in filing notices that it would be late with its audits, according to Smith. "We would not advise Siebert to proceed if we believed there was any chance of violating [SEC rule] 15c2-12," he said.

"Our assumption is not that Detroit is timely; the assumption is based on whether they've met their disclosure obligations," he said. "There are several issuers across the country that at the time of issuing bonds may be late with their audits - that's not unique to the city of Detroit. Their obligation is to disclose that they are going to be late and indicate a date in which they expect to submit their final audit."

The city's recent hiring of finance director Joseph Harris is evidence of a renewed effort to begin to meet audit deadlines, several sources said. A former Detroit auditor general, Harris is considered an important hire in helping the city clean up its financial muddles.

"The key here is if they are bringing themselves into compliance," one bond attorney familiar with the city said. "Joe Harris is making a concentrated effort to clean up all the accounting so they can produce products on time, and the tone of the discussions over the late audits has changed."



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