CHICAGO — Detroit’s newly filed 2012 comprehensive annual financial report warns that the city faces a substantial challenge from costly pension bond derivatives, including possible interest-rate swap termination payments as high as $440 million.

The city filed its CAFR on Dec. 31, 2012, marking the second timely filing in a row after years of late audits. The city is required to file its annual audit on time in order to secure its regular revenue sharing payment from the state.

The audit comes two weeks after Gov. Rick Snyder declared Detroit to be in a state of fiscal emergency and appointed a review team to investigate its books. The move is widely seen as clearing the way toward appointment of an emergency manager.

The audit, conducted by KPMG LLP, shows the city had an unassigned general fund deficit of $327 million as of the end of June 30, 2012. That’s up $130 million from the end of 2011.

The city managed to operate despite very thin liquidity by borrowing bonds through the state as well as transferring more than $90 million into its general fund from the solid waste, risk management and street funds, the audit showed.

The general fund’s cash and investments totaled $60 million at the end of June, 2012 compared to $74 million at the end of fiscal 2011.

Hanging over the city’s dire fiscal situation is the threat of having to make massive cash payments to banks that hedge more than half of the city’s $1.5 billion of 2005 pension obligation certificates.

City budget director Cheryl Johnson said Detroit is continuing to negotiate with the swap counterparties for relief.

“The negotiations are underway and we have no final agreement,” Johnson said in an email to the Bond Buyer. “We will have no comment until an agreement is reached.”

The city issued $1.5 billion of pension bonds in 2005. Roughly $800 million is hedged in eight separate interest-rate swaps with two counterparties, UBS and Siebert, Brandford, Shank & Co.

It’s at least the fourth year that the city has struggled to stave off payments triggered by termination events.

The 2011 CAFR also warned of the threat to the city’s cash position if it is forced to make the payments.

The city already negotiated major changes to the interest-rate swaps when termination events were first triggered in 2009. Under that agreement, the city agreed to set aside casino revenue as collateral and the counterparties waived their right to termination payments unless the pension bonds were downgraded below Ba3 or equivalent.

Moody’s Investors Service last March downgraded the bonds to B2 from Ba3. City officials said then they were negotiating with the counterparties.

“If the termination events are not cured, there presently exists significant risk in connection with the city’s ability to meet the cash demands under the terms of the amended swap agreements,” the 2012 audit says.

The pension bonds were meant to provide full funding for Detroit’s two pension plans. The city’s liabilities for the two plans total $7.5 billion as of the end of fiscal 2011, the most recent valuation, of which $644 million is unfunded, according to the audit.

Detroit has another $5.7 billion in unfunded obligation for its other postemployment benefits.

The general fund deficit increased by $130 million for several factors, primarily falling state aid and property tax revenue, the city said in the audit.

Cuts that helped hold down the deficit included $20 million in salary reductions and $31.5 million in pension cost reductions due largely to improved market performance.

Detroit’s total bonded debt rose by $772 million during the year due largely to the issuance of $1.2 billion in new revenue bonds by the water and sewer departments. That debt is paid for with water and sewer fees.

The city’s long-term obligations totaled $9.4 billion for fiscal 2012, up from $8.7 billion the previous year. Detroit had $6.4 billion of outstanding bonds as of the end of fiscal 2012. That includes $1 billion of general obligation bonds and $5.4 billion of revenue bonds and does not include the POCs.

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