Detroit May Face Huge Termination Fees for Swaps

CHICAGO — Detroit, which is edging closer to a state takeover, could be on the hook for hundreds of millions in termination fees tied to its derivatives contracts on more than $2.5 billion of outstanding debt if the state appoints an emergency manager.

Michigan Gov. Rick Snyder said Friday that the state will launch a review of the city's finances, a 30-day process that marks the official start of a state intervention.

The process sets the stage for the appointment of an emergency manager. Such a move would trigger termination events on swaps that hedge $948 million of pension obligation certificates issued in 2006 and $1.6 billion of water bonds.

Detroit in early 2009 narrowly avoided a $400 million termination fee tied to the pension certificates after it was hit with a downgrade that prompted a termination event. Local officials negotiated for months with the two counterparties to achieve an amended agreement that avoided the payment. If the state appoints an emergency manager, Detroit would face the same problem again.

"The city would then be in a situation where it would be forced to pay the counterparties or go into negotiations as they did in January 2009," said Edward Damutz of Moody's Investors Service."We're closely monitoring the situation as it unfolds. While there is the potential negative of the appointment of an emergency manager triggering swap termination events, an EM does have increased powers to open up contracts with the unions."

UBS AG and SBS Financial Products Co., which is part of Siebert Brandford Shank & Co., are the counterparties on the pension obligations. UBS declined to comment and a Siebert representative did not return phone calls by press time.

Last April, Fitch Ratings downgraded the city's $2.1 billion of water bonds, citing in part an extensive derivative program at the Detroit Water and Sewerage Department that hedges $1.6 billion of the debt.

"In recent years the negative fair value of the department's swaps have risen, increasing the termination risk associated with the swaps," Fitch's Doug Scott wrote. "Should the department be required to post collateral, it would negatively affect the department's financial profile to some extent."

The city is planning to come to market with a water bond refunding to shed the swaps and avoid termination payments. The price tag of the termination fees remains uncertain, but it would likely be in the hundreds of millions. At the end of 2010, the negative valuation of the water and sewer bond swaps was $165 million.

All three major rating agencies maintain junk ratings on the city's general obligation debt. Detroit has $453 million of unlimited-tax GO debt and $486 million of limited-tax GO bonds.

Even as the state formally launched a review into the city's finances Friday, Michigan Treasurer Andy Dillon said he hopes to avoid appointment of an emergency manager or even the less-dramatic option of a consent agreement, which would keep local officials in office but give them greater powers.

Dillon said the state decided to start the 30-day financial review after a recent audit showed Detroit could run out of cash by April. "Time is running short," he said in a conference call with reporters.

He said the state would suspend the process if local officials can agree on a plan to tackle the city's fiscal problems. Dillon said that the city's current proposals fail to address the city's long-term liabilities.

"Most people are focusing on the cash shortfall that begins in April, but the city also has significant debt on its balance sheet, and long-term how they can sustain that is a concern of ours," he said. "What's the long-term solution for the city, and how are we going to start addressing long-term liabilities, whether bonds or health care costs?" q

The appointment of an emergency manager would be considered a positive for at least one investor who buys Michigan bonds. "From a political standpoint, Detroit has always been very secretive, and it's been Detroit versus Michigan to some extent," said Brad Reynolds, chief investment officer for LJPR LLC. "I would welcome seeing what an independent financial review says."

If the review finds evidence of fiscal stress, the governor will appoint a team to launch a formal, 60-day review.

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