CHICAGO - Bankrupt Detroit warned it might sue its bank counterparties if a more favorable settlement to terminate costly interest-rate swaps can't be brokered during federal mediation beginning Monday.

The stakes are high if the city and banks are to avoid prolonged litigation over the status of the swaps.

The warning came from attorneys for Detroit during a brief status hearing Friday before U.S. Bankruptcy Court Judge Steven Rhodes, two days after the judge suspended hearings on the settlement and a proposed $350 million debtor-in-possession financing with Barclays.

The settlement relies on about $230 million from the DIP loan to cover the termination payments on swaps that hedge the city's pension certificates. The settlement is opposed by several bond insurers and city pension funds who believe it offers the banks and Barclays overly favorable of terms at the expense of other creditors.

Detroit's attorneys told the judge they are attempting to negotiate a new deal, according to published reports.

Mediation hearings between the city, the settlement's objectors, swap counterparties USB AG and Merrill Lynch Capital Services Inc., bondholders, and others are set for Dec. 23 and 24, according to an order form U.S. District Court for the Eastern District of Michigan Chief Judge Gerald Rosen who is leading the mediation.

If a new settlement is reached with terms more acceptable to the bankruptcy court, mediators, and the original deal's objectors, the city's emergency manager would be deposed on it Dec. 31 and hearings on the DIP deal and swaps settlement could resume Jan. 3.

Orr will be "fully prepared to testify [on Dec. 31] to the city's decision to enter into any such agreement that results from this process," city attorney Thomas Cullen of Jones Day told the judge, according to numerous published reports. "In the interim, we're bound to do whatever is necessary to protect the city, residents and interests and preserve the city's ability to take whatever course of action it deems necessary.

"We will litigate our rights if an agreement is not reached," Cullen reportedly said. The swap counterparties declined to comment Friday on the city's threat or mediation.

Detroit first disclosed it was leaving open the possibility of suing the banks during a hearing Wednesday as Orr and city attorneys from Jones Day resisted pressure from Rhodes to disclose the city's strategy behind its treatment of the swap debt and decision to negotiate a settlement. The city has given the swaps "secured" status and the settlement offers a roughly 75 cents to 82 cents on the dollar payout.

The city has lumped most of its general obligation debt and pension in the "unsecured" category with much steeper haircuts proposed. In filings, the city has acknowledged there are issues it could litigate involving the status of the swaps -- as the settlement's objectors have argued - but said any litigation would be prolonged and tie up access up to much-needed city casino revenues which generate $170 million annually and serve as collateral on the swaps.

During the hearing Wednesday on the settlement and DIP, Rhodes asked: "How can I decide whether this was a fair settlement without understanding" the city's arguments on the legality of the swaps, according to published reports.

Orr and Jones Day attorneys cited attorney-client privilege as a reason not to outline the city's position on the swaps' legality, with Jones Day attorneys saying that "one of the reasons we haven't disclosed those memoranda is because we may still sue the banks."

At an impasse with Rhodes and attorneys for the pension funds and Syncora, the city suggested a temporary delay in the hearings which had been scheduled to last through Thursday. Rhodes suspended the hearings, scheduled the status conference for Friday, and urged the city to attempt to use the time to renegotiate the swap settlement. Rosen's mediation order requires the participation of Orr; the bank counterparties; and the settlement objectors including insurers Syncora Gurantee Inc. and Berkshire Hathaway Reinsurance Group which wraps insurance from Financial Guaranty Insurance Co.; as well as other insurers and a committee representing holders of the pension certificates tied to the swaps.

Also on Friday, the state's Emergency Loan Board approved the DIP loan after hearing presentations from city officials, the city's investment banking firm, and objectors. The board has a say in such fiscal matters under the emergency management law.

James Doak, managing director at the city's investment banking firm Miller Buckfire, told the board the percentage and & termination amount of the swaps deal "is the subject of active dialogue" and said any lowering of the payout could result in more funding for city services and projects.

"This financing, if approved by the bankruptcy court, will provide significant financial resources to invest in Detroit's infrastructure and other restructuring initiatives. In addition to addressing critical, quality of life projects, this proposal will also eliminate future liabilities related to questionable financial transactions from years past," Gov. Rick Snyder said in statement after the board gave approval.

It's unclear how the bankruptcy court's delay in approving the DIP financing and settlement will impact Orr's plan to release next month a proposed restructuring known as the plan of adjustment. Orr has called the transactions which would free up casino revenues central to his restructuring plans. The city entered Chapter 9 in July with $18 billion in debt.

Under the deals, a pledge of the city's casino revenues which currently backs the swaps will be shifted to the DIP deal. City income taxes would also be pledged. The DIP agreement with Barclays expires on Jan. 7, 2014.

The DIP financing consists of two loans: "Swap Termination Bonds," totaling $230 million, and the "Quality of Life Bonds," totaling $120 million. The loan features a super-priority lien for Barclays on income tax and casino revenues. The $350 million notes carry an interest rate based on the London Interbank Offered Rate plus 2.5%, plus a 1% LIBOR floor, translating into an effective rate of 3.5%.

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