CHICAGO - After months of negotiations, Detroit has reached a settlement with two counterparties that allows it to avoid swap termination payments of up to $400 million tied to downgrades of the city's debt.

The settlement - which still must be approved by the City Council - comes as Detroit prepares to enter the market Friday with roughly $128 million of revenue anticipation notes to pay for operating costs through the end of its fiscal year.

Under the terms of the swap settlement, the city will pledge casino tax revenue as collateral and pay an additional $800,000 in interest rate payments beginning in 2011, officials said. In return, the counterparties agreed not to terminate the swaps, a move that could have cost the city $400 million in upfront payments based on recent interest rates.

The agreement removes a "huge weight" from Detroit's balance sheet, Mayor Ken Cockrel Jr. said in a statement. The city had hired two public finance law firms to help negotiate the settlement with the counterparties, UBS AG and SBS Financial Products Co., which is part of Siebert Brandford Shank & Co.

The experience has soured the city on entering into swaps for the time being, said chief financial officer Joseph Harris.

"We're going to shy away from swaps in the future," he said. "I don't see anybody at the city willing to stick their necks out. We'll negotiate either fixed-rate securities or we'll have to live with variable-rate debt, at least for the near future."

Under the agreement, Detroit will place its casino tax revenue - which totals roughly $180 million annually - with a custodian, US Bank NA, every month. Once the city makes its monthly payments to the counterparties, the casino revenue will be released back to the city, said Harris.

The swap payments total $4.2 million a month, or $50 million a year, and are paid from the city's general fund, Harris said.

In addition to pledging its gaming revenue, Detroit agreed to pay $800,000 more in annual interest payments starting in 2011. The additional payments represent a roughly 1.5% increase in the city's interest rate. It currently pays a 5.67% rate to the counterparties on the floating-to-fixed rate swaps, Harris said.

"Since we're below investment grade, they wanted some type of collateral, and this is what we worked out," he said. "It's a means of assuring them they'll get paid."

The swaps are tied to $800 million of taxable pension certificates of participation issued in 2006. The agreements are insured by XL Capital Assurance Inc. - now Syncora Guarantee Inc. - and Financial Guaranty Insurance Co., both of which have lost their investment-grade ratings.

Under the swap agreements, the counterparty can terminate the agreements in the event that the certificates' ratings are withdrawn, suspended, or dropped below investment grade by one of two rating agencies, and at least one rating agency drops the insurers' ratings to below the single-A category.

While there was some reason to expect the loss of the city's investment-grade rating, no one expected the insurers to be downgraded, according to Harris.

"No one would ever have predicted this whole fiscal meltdown," he said.

In January, all three rating agencies downgraded Detroit's nearly $900 million of outstanding general obligation debt and $1.5 billion of pension COPs to junk status. Analysts cited a slew of economic and financial problems, chief among them a $300 million deficit and chronically late financial audits.

In late February the city released its long-delayed 2007 audit, and has said the 2008 audit would be completed by August.

Analysts cited resolution of the possible termination payment as important to the city's credit. As of yesterday, Harris said officials had not yet talked with analysts about the settlement.

On Friday, Detroit is scheduled to sell $128 million of revenue anticipation notes. Proceeds will be used to pay operating costs for its current fiscal year, which ends June 20. The notes, which mature March 1, 2010, will be paid for with the city's receipt of $276.5 million in state shared revenue funds next year.

Morgan Stanley is senior manager on the deal with Loop Capital Markets LLC as co-senior.

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