CHICAGO -- U.S. Bankruptcy Judge Steven Rhodes Friday approved Detroit's controversial $85 million interest-rate swaps settlement, resolving one of the thorniest aspects of the city's Chapter 9 case.

The ruling came in the same week the city announced a deal with the bond insurers who wrap Detroit's unlimited-tax general obligation bonds. With the two agreements, the bankruptcy case has gained momentum -- but major hurdles still lay ahead, legal experts said.

It was Detroit's third effort at winning court approval for the swaps settlement. Rhodes had rejected the earlier deals as too costly in light of the ambiguous legality of the casino revenue lien that backs the swaps and the settlement.

The judge said in his ruling that the latest deal is reasonable and marks a 70% reduction from the first proposal.

The settlement is the "fastest, surest and least costly way" for the city to reach its goal of exiting bankruptcy by Oct. 15, Rhodes said. He added that a ruling on the casino lien isn't necessary for the settlement to be approved.

The ruling marks a victory for Detroit emergency manager Kevyn Orr and the swaps counterparties, UBS AG and Merrill Lynch Capital Services. It's a loss for Syncora Guarantee Inc., which has devoted significant legal resources to fighting the deal. Syncora insures the swaps and could now be forced to pay the banks $200 million to cover the full cost of the termination payment.

The settlement also gives Detroit the important legal ability to impose a cramdown plan on the rest of its creditors.

After his ruling, Rhodes once again urged the city and its creditors to reach out-of-court settlements.

"The city's plan of adjustment may now be eligible for a cramdown judgement," the judge said, according to the Detroit Free Press and other local reports of the hearing. "The message is that now is the time to negotiate, not on the eve of the confirmation hearing in July."

He urged the parties to work with the court-appointed mediators, who have shown "unprecedented energy, enthusiasm, and dedication." The mediators helped the city and the ULTGO bond insurers reach their settlement.

Despite last week's victories, the city faces headwinds as it tries to reach settlements with the creditors making up the bulk of its debt: the city's pensioners.

"While all these other settlements are significant, the pensions will be the linchpin to getting a plan that will get approval," said Michael Sweet, a bankruptcy attorney at Fox Rothschild. "The plan can still be approved without resolution, but that would make it so much easier. The most important thing that needs to happen is resolution of the pensions."

The pension matter was complicated last week when a bond insurer reported to Rhodes that it had obtained four bids of up to $2 billion for the art collection of the city owned Detroit Institute of Arts museum.

Insurer Financial Guaranty Insurance Co., was joined by Syncora and the city's largest union in its motion asking Rhodes to force the city to consider the bids to help pay off creditors.

Orr is pushing for a so-called grand bargain that features $816 million of private and state contributions. The money would all go toward pension payments and would protect the art from sale or monetization.

The fact that the art is in play shows the high stakes of trying to restructure a once-great American city, Sweet said.

"The case is on really bringing a lot of tough issues to the surface," he said. "It just goes to show what a shame it was that Detroit, once of the wealthiest cities, didn't plan better as it moved into the 21st century."

The swaps and proposed ULTGO settlements represent only a fraction -- about $600 million -- of the city's estimated $18 billion of debt, said David Tawil, co-founder and portfolio manager at hedge fund Maglan Capital and former bankruptcy lawyer who had Rhodes as a law professor at the University of Michigan law school.

"At the outset, when people thought about this bankruptcy case, these were two almost non-issues," Tawil said, noting that the city has been negotiating with the swaps banks before it even filed for Chapter 9.

"We have yet to deal with the larger, much more important and bigger dollar issues in this case," he said. "If the stories about the artwork are true, the judge is going to have a very, very difficult time figuring out how to resolve this."

For the muni market, Tawil said the swaps dispute will likely mean more careful transactions between banks and municipal issuers in the future, with a greater eye on disclosure, liens and risks.

In his ruling Friday, Rhodes said the record supports the city's argument that the deal is reasonable and brings certainty to the case. He acknowledged questions surrounding the legality of the casino pledge, but agreed with the city that "it was certain that any such litigation would be expensive and, considering litigation, take years."

Detroit's attorneys argued at an all-day hearing on the issue last week that the court had the power to approve the casino lien, despite the legal uncertainty.

"Questionable liens are settled every single day in every single bankruptcy court across the nation," Pepper Hamilton attorney Robert Hertzberg said.

Rhodes appeared to agree with that assessment in his ruling, saying it is "beyond serious dispute" that a settlement can be struck even if a lien is questionable.

"As the city argues, nothing in law requires to litigate the validity of the lien," he said. "Rather, the law allows compromise."

Under the settlement terms, Detroit would pay $85 million to UBS and Merrill Lynch. The city would pay off the banks in a series of quarterly payments, and expects to make the full payment after Oct. 15 — its expected bankruptcy exit date — with proceeds of a $300 million post-petition financing from Barclays. After Oct. 15, the city would have to start paying interest on the obligation.

Until full payment is made, the swaps would not be terminated and the rights of the banks would remain in place. The banks could still terminate the swaps, but could not demand additional money from the city.

Rhodes noted that the parties would not be able to sue each other in the future, and that the banks would support the city's bankruptcy plan. But the judge also said the city "retains the right to argue the invalidity" of the casino tax pledge, as well as the original $1.5 billion pension certificate deal.

Rhodes overruled all of Syncora's objections, but said the insurer still has the ability to sue the banks for breach of contract.

The derivatives hedge roughly $800 million of $1.4 billion of pension certificates of participation that the city is separately trying to repudiate as illegal.

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