CHICAGO -- Look out, bondholders.

Detroit won’t survive unless it can restructure its long-term debts, the city’s emergency manager, Kevyn Orr, said in a new report on the city’s fiscal condition.

The eagerly awaited report, mandated under state law, provides the first full look at Orr’s analysis of the city’s fiscal condition. It puts bondholders and bond insurers on notice that haircuts will likely be part of the city’s negotiations for much of its debt, but offers few concrete insights into his restructuring plans.

The 44-page report outlines four debt-relief options that one bankruptcy attorney called “restructuring 101.” The options include reducing principal, pushing off near-term debt payments, reducing interest rates, and financing “cash recoveries” by issuing new debt.

“If you’re holding Detroit bonds, you already had plans and knew this,” said Douglas Bernstein, practice group leader for the banking, finance, and creditors’ rights group at the Michigan-based law firm Plunkett Cooney.

As expected, Orr’s review paints a grim picture of the city’s finances. Expenditures exceeded revenues by an average of $100 million a year from 2008 to 2012 -- shortfalls that the city masked with deficit borrowing and by deferring pension and other payments.

These deferred payments totaled $226 million as of the end of April. Detroit would run out of money by the end of next month if it did not defer pension payments and tap proceeds from a bond-financed escrow account controlled by the state.

Junk-level credit ratings and the legal debt limit have “effectively exhausted” the city’s ability to borrow, the analysis says.

Orr also warns that the city’s pension funds, considered relatively healthy because of a 2005 pension borrowing, could be significantly less well funded than estimated.

“No one should underestimate the severity of the financial crisis,” Orr said in a statement Sunday, calling the report a “sobering wake-up call about the dire financial straits the city of Detroit faces.”

The city is expected to release more details in the next 60 to 90 days.

“Restructuring the city’s liabilities in a fair and equitable manner across all relevant stakeholders is necessary for the city’s operational and financial survival. In fact, it is overdue,” Orr said in the report. “Without a significant restructuring of its debt, the city will be unable to break the cycle of damaging cutbacks in essential municipal services and investments.” 

The report does not contain much news for Detroit debt holders, but it does keep them on notice that some kind of adjustment will be necessary, Bernstein said.

“The positive side of the report may be here are the numbers, put together by an objective third party, for all to see,” Bernstein said. “Anybody who’s a creditor is going to see how big the hole is and how obvious it is that concessions are needed.”

Nearly all of the city’s debt is insured, and Orr is expected to  negotiate, at least in the early rounds, mostly with the insurers.

Orr does not mention bankruptcy in the report, but it is the cudgel hanging over the restructuring process, Bernstein said. It’s nearly certain that the city will end up in bankruptcy court, driven there by the inability to achieve agreements from all creditors, he said.

“Nobody is going to want to be first,” said Bernstein. “And I would bet that it’s the pension obligation that’s going to be the tipping point.”

Orr echoes Michigan Treasurer Andy Dillon’s recent hints that the city’s two pension funds are far less well-funded than previously estimated. The funds are underfunded by at least $600 million, but that the liability could rise “into the billions” when updated with more current data and conservative assumptions, the report said.

Municipal Market Advisors, in its weekly market outlook, says Orr sends mixed messages in the report, and that bondholder haircuts are not necessarily inevitable.

“There is no doubt that the city needs to restructure its liabilities to match its resources and that doing so is considered paramount in the emergency manager’s report,” MMA wrote. “However, the actual EM report does not seem to suggest that a specific course of action has been determined for the ‘funded debt obligations.’”

The city’s general fund services $511 million of unlimited-tax general obligation bonds, $576 million of limited-tax GO bonds, $1.45 billion of pension obligation certificates, or POCs, and eight interest-rate swaps that hedge the pension debt and were valued at negative $377 million as of the end of March.

Debt service on the POCs is set to double over the next several years, rising to $56 million in 2023 from $23.1 million in 2013. The pension debt already poses one of the largest strains on the general fund budget, the report said. Market experts who rank the debt consider it among the most vulnerable to reductions.

The report seems to suggest different debt could be treated differently, MMA said. “Given the debt-service trends, the structure of the POCs, and their association with the swaps, the emergency manager may be signaling that a different approach may be taken for the restructuring of each category with the implication of possibly more favorable treatment of GOs,” MMA said.

Any haircuts, especially on the GO debt, would have a major impact on the city’s future borrowing ability and would pose a threat to other Michigan cities’ borrowing ability, MMA warned. “Frankly, the added cost spread to other issuers could offset, on a statewide basis, all or a portion of the local savings created by haircuts on Detroit bondholders/guarantors.” Debt-service payments will gobble up 19.3% of the general fund budget in fiscal 2013, according to Orr. The city has been negotiating since last year with the banks that are swap counterparties. The report included no new information on the attempt to resolve the problem, saying only that negotiations will continue as part of the restructuring process.

The city has $5.9 billion of water and sewer debt that is paid off with revenues from the Detroit Water and Sewerage Department. The enterprise debt is considered by market participants to be among the safest from restructuring.

The city’s obligations total $15 billion, including $1.1 billion of general fund debt, $6 billion of enterprise debt, $1.8 billion of pension and related interest rate swap debt, $5.7 billion of other post-employment benefit liabilities, and at least $600 million of unfunded pension obligations.

Gov. Rick Snyder declared Detroit to be in a fiscal emergency earlier this year and Orr, a Jones Day bankruptcy attorney, took over on March 25. State law requires emergency managers to release financial reports within 45 days of taking office.

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