CHICAGO — Moody's Investor's Service has downgraded $4.6 billion of Detroit sewer and water system revenue bonds citing a decline in debt service coverage, looming capital needs, and the risks associated with derivatives.

The rating agency lowered its rating to A1 from Aa3 on $1.43 billion of senior lien sewage revenue bonds. About $1 billion of second lien bonds were downgraded to A2 from A1. A negative outlook at the lower level was assigned to the debt that is secured by net revenues of the city's sewage disposal system.

Moody's lowered its rating on $1.54 billion of senior water revenue debt to A1 from Aa3 and its rating on $660 million of second lien bonds to A2 from A1. A negative outlook also was applied to the water bonds that are secured by a pledge of net revenues generated by the system.

The downgrades mark the latest in a series of negative credit actions to impact the fiscally struggling city which carries a junk bond general obligation rating.

The systems' strengths include the large metropolitan area they serve that spans a wide swath of suburbs and the impending implementation of a new model for wholesale contracts. In the case of the water bonds, Moody's also cites an ample supply of water from the Great Lakes as a credit strength.

The systems' challenges include significant exposure to swaps with poor levels of liquidity to honor payments in the event that the swaps are terminated at current values. The systems are highly leveraged with more capital work needed. The systems are further challenged by a drop in unrestricted net assets and weak legal covenants.

"The negative outlook reflects our expectation that debt service coverage will likely remain lean and the system will remain challenged in maintaining satisfactory operating margins in the near term," Moodys' wrote in both reports issued late Monday.

The city has converted all of its floating-rate bonds with tender options issued under both programs to fixed rate, terminating many of its swaps and entering new ones.

The combined mark-to-market valuation on the sewer system's swap agreements was approximately $193.4 million payable to counterparties upon termination as of June. The water system's mark-to-market valuation was at $175.5 million.

The Detroit sewage disposal system serves 3 million customers in an 850 square mile area that includes both the city and 77 suburban communities in triple-rated Oakland County, Aa1-rated Macomb County, and A3-rated Wayne County. Moody's rates Detroit's unlimited tax general obligation credit in junk bond territory at Ba3 with a negative outlook and its limited tax credit at B1 with a negative outlook. The breadth of the service is a credit strength as customer losses in Detroit are offset by suburban gains.

Annual rate increases over the last five years have generally kept pace with increased debt service.

While the sewer system's managers have reduced operational and maintenance costs and improved collections, an unforeseen decline in service demand and revenues has lowered debt service coverage to 1.75 times on senior bonds and 1.23 times on second lien bonds.

A further drop is expected to 1.45 times and .98 times, respectively, after audited fiscal 2010 results are released. Coverage is expected to rise by fiscal 2012 to above 2 times with the boost from additional rate increases.

The sewer system includes a treatment plant, a collection system with about 3,000 miles of trunk and lateral sewers, 11 pumping stations, and three interceptors in the city. About $1.7 billion of projects were scheduled through 2012 but managers have put some on hold. "The city faces potentially large capital expenditures in the future to continually meet increasingly stringent environmental regulations," Moody's wrote.

The water system serves 4 million in Detroit and 124 area communities, making it one of the largest systems of its kind in the country. Like the sewer system, city customer losses have been offset by suburban gains.

The system historically has seen narrow operating margins with coverage ratios aided by annual water rate increases. Unforeseen declines in water usage lowered coverage ratios to a narrow 1.25 times for senior debt and .89 times for second lien debt in 2009. Although additional rate increases were enacted, officials expect only a slight improvement to 1.31 times and .92 times, respectively, for 2010, before rising to more than 1.55 times and 1.11 times in 2012.

The system's managers previously had planned on $1.2 billion of capital spending, including $620 million in new borrowing, through 2013 but those plans have been scaled down so that just $200 million to $300 million of new debt in now planned.

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