CHICAGO — Bondholders of the nearly $6 billion of Detroit water and sewer debt hold one of the strongest hands for recovery as Detroit emergency manager Kevyn Orr tries to restructure the city's massive debt load.

Orr is in the midst of closed-door negotiations with creditors that he said could determine as soon as next week whether he will file for bankruptcy.

The $5.9 billion of water and sewer debt represent the city's largest chunk of bonds and has long been considered among its most secure. The Detroit Water and Sewerage Department is one of Detroit's healthiest assets, serving a large swath of the state, and one of the largest departments in the country.

The bonds enjoy a coveted statutory lien and debt service coverage levels that are considered relatively strong, at around 1.2 times for the senior-lien bonds.

But as one analyst put it, "overconfidence and complacency would be a mistake."

Standard & Poor's and Moody's Investors Service both dropped the debt into junk territory over the last few weeks, with S&P downgrading it nine notches. The downgrades reflect the rising risk of default from a city that is already in default on other bonds, as well as the risk of losses to bondholders under Orr's proposal to restructure the debt, analysts said.

A key to Orr's plan to restructure the Motor City, shed its nearly $20 billion of debt, and generate new revenue is to lease the water and sewer system to a new authority. The move would require a massive restructuring of the water and sewer debt.

If he can persuade the bond insurers who insure nearly all of the revenue bonds to agree to the restructuring — which would likely include some kind of impairment — it could smooth the Chapter 9 process, said one attorney.

"If it's a payment schedule they can live with, it goes a long way to potentially shortening the process," said Douglas Bernstein, practice group leader for the banking, finance, and creditors' rights group at the Michigan-based firm Plunkett Cooney.

"[Insurers] may be willing to short-circuit the process rather than endure the bankruptcy, which could easily be three years," he said.

Settling out of court also reduces uncertainty, he noted. "Everyone has got a tremendous amount of risk," he said. "Do you really want to test the law in this case?

The new water and sewer agreement would be likely be structured as a long-term lease of the assets, with Detroit retaining ownership, in order to generate a fresh revenue stream for the city. The new authority would pay Detroit annual revenues estimated in a recent report at around $50 million.

Orr's debt restructuring proposal divides holders of the current water and sewer bonds into two classes: Class A, which includes all callable bonds, would be repaid with a cash payment after the transaction. Class B would receive restructured bonds.

Both classes include senior- and subordinate-lien bonds, and all the new debt would have a lien on net revenues but be subordinate to the operating and maintenance costs of the system as well as the annual payment to the city.

The plan would likely take months to cement. The state Legislature would need to create the new authority, and the suburban governments would need to agree to the structure.

The size of the annual payment to the city could prove controversial for regional governments. The annual payment would also open the authority's revenues to the city's general fund, traditionally isolated from the department, and could weaken coverage levels and the bottom line, credit analysts said.

All of the water and sewer debt, with the exception of $476 million with a 2041 maturity, is insured. National Public Finance Corp., a subsidiary of MBIA Inc., and Assured Guaranty Ltd., insure $4.3 billion. FGIC insures another roughly $1.5 billion. Berkshire Hathaway Assurance Corp. wraps just under $400 million of sewer bonds on top of the FGIC guarantee.

The treatment of the debt as special revenue bonds not subject to an automatic stay in a bankruptcy court is likely, though not guaranteed, said bankruptcy attorneys.

But Orr is aiming for an out-of-court agreement with the insurers. The corporate bankruptcy attorney has said repeatedly he wants all creditors — secured and unsecured — to take a cut as part of a political gesture to help save the ailing city.

The restructuring plan starts the dialogue with the water and sewer bondholders.

"The emergency manager is saying, 'We need to provide essential services here in the city, and we need help from everybody that can contribute. Regardless of what you may perceive as your rights, we need a contribution from everybody'," said bankruptcy attorney James Spiotto at Chapman and Cutler LLP. "Bondholders are driven by what rights they have, but to ask for adjustments to that which wasn't supposed to be adjusted can at the least start a dialogue and some questions."

Spiotto noted that asking for an impairment could drive up future borrowing costs, translating into long-term debt for a short-term gain. A haircut on the water and sewer bonds could drive up interest costs by 1% or 2%. That adds up over the life of  a 30-year bond, Spiotto said.

"What gain do you get from nicking somebody short term when you're going to pay 60% higher [interest costs] over the next 30 years?" he asked.

The move to ask secured creditors for a haircut is a move more often seen in Chapter 11 than Chapter 9, said Richard Ciccarone, chief research officer at McDonnell Investment Management.

"Even if it's just done through political pressure, if they can get people to waive their natural rights under Chapter 9, it's using an intimidation approach that looks more like a Chapter 11," Ciccarone said. "In Chapter 11, the senior secured debt still has the potential to get 100%, just as we're expecting on senior bonds in Detroit water and sewer," he said. "But not without [holders] having to participate in the negotiations and maybe actually having to cut deals that might temper the timing [of debt payments] or the tender date," he said. "They have the strongest hand going into the discussions, but being overconfident and complacent would be a mistake."

Matt Fabian, managing director of Municipal Market Advisors, said he'd be surprised if the creditors agreed to a settlement.

"It's very hard to see the insurers agreeing to something below par this early in the process," Fabian said. "The court is pretty clear, and it seems like Orr is looking for concessions beyond what the law would allow," he said. "He would be appealing to the creditors to give us something, and maybe there are ways to encourage their agreement."

One credit analyst and portfolio manager at a large asset management firm, who asked to remain anonymous, said it would be a mistake for the insurers to agree to a restructuring. "The water and sewer bonds are not immensely strong, and coverage has been thin, but it's been adequate," he said. "The last option for them should be to compromise the water and sewer bonds, which have been paying their debt service all along."

Orr's plan for the new water authority is based largely on a March report from the so-called Root Cause Committee, created to explore ways to monetize the department.

The plan calls for the new Metropolitan Area Water and Sewer Authority to set up its own retirement plans for new and current employees, but the city would retain the pension and retiree health obligations for the current department. Those liabilities would be subject to the same agreement reached for the rest of the city's retirement systems from Orr's current negotiations or a Chapter 9 settlement.

In exchange for the assets and for relief from the water and sewer legacy obligations, the new authority would pay the city a monthly fee, likely in the form of a payment in lieu of taxes. Orr does not name a dollar amount, but the root cause committee estimates it at $50 million.

A piece of the water and sewer bonds with a 2041 maturity sold for 89 cents on the dollar in Wednesday trading. Another chunk sold for 90 cents on the dollar. Bids for Detroit pension certificates, which the city defaulted on in June, came in between 36 cents and 40 cents on the dollar in Wednesday trading.

Christine Albano and Taylor Riggs contributed to this story.

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