CHICAGO - Moody's Investors Service this week hit Detroit with its second downgrade so far this year, pushing the beleaguered city's debt deeper into junk-bond territory and warning of further fiscal and economic challenges on the horizon.

At the epicenter of the damaged U.S. automobile industry, Detroit suffers from a 28.2% unemployment rate, a $275 million accumulated deficit, and falling revenues that have led some officials to talk publicly of the possibility of filling for bankruptcy.

The latest downgrade comes a few weeks after Mayor Dave Bing, who recently completed his first 100 days in office, and his new financial team visited rating agencies in Chicago to discuss the city's finances. As of late Monday the mayor's office had no comment on the downgrade, which puts Detroit among Moody's lowest-rate municipalities in the country.

In its downgrade, Moody's cut the city's $491 million of unlimited-tax general obligation debt to Ba3 from Ba2, and $290 million of limited-tax GO debt to B1 from Ba3.

Moody's also downgraded to Ba3 from Ba2 the rating on roughly $1.5 billion of outstanding taxable certificates of participation issued for the city's pension systems.

The outlook on the debt is negative, as Moody's expects Detroit will continue to struggle, according to analyst Elizabeth Foos. "They've got quite a few challenges ahead of them," Foos said.

The city's "severe fiscal stress" is reflected in its large deficit, limited financial information, and economic declines throughout the region, Foos wrote in a report released late Friday. "The city's weak financial position necessitates an increased reliance on short-term borrowing for cash-flow purposes, which is likely to be increasingly difficult to obtain in the current market."

The city's top two revenue streams, state aid and municipal income taxes, are both in decline, as are casino revenues for the first time this year. Aggravating Detroit's woes is a revolving door of political leadership, with three mayors in office since last September.

The city could face additional problems from the outstanding floating-to-fixed-rate insured swaps tied to its pension COPs, Moody's warned. It recently negotiated amended swaps with its counterparties allowing it to avoid possible $400 million termination payments, and the amended agreements removed the immediate threat to the city's liquidity. But the risk of termination remains a credit concern, as the city would be unable to make the payment, Foos said.

The Bing administration expects to close a current $70 million operating shortfall and report a balanced general fund operation in fiscal 2010, while carrying over the $275 million accumulated deficit. The next short-term borrowing, which is usually scheduled for March, is expected to be larger than in the past, Moody's said.

It has been a year of downgrades for Detroit. Since January, all three rating agencies have cut the city's GO debt into junk-bond territory. Standard & Poor's rates Detroit's $2.4 billion of limited- and unlimited-tax GOs at BB and its pension certificates BB. Fitch Ratings rates the unlimited-tax GOs at BB, its limited-tax GOs at BB-minus, and its pension COPs at BB.

The downgrades mean higher costs for the city on its outstanding bonds - in afternoon trading yesterday, Detroit's GO debt was yielding 7.25% on a 5.25% coupon, and its Baa1-rated Downtown Development Authority debt was yielding 9.9% on a 6.68% coupon. It could also mean less new-money issuance from local and state issuers in Michigan going forward, said Michael Alandt, executive director of the Municipal Advisory Council of Michigan.

"Issuance is already down right now at least 30%," he said. "The first quarter was really bad, though the last two months have been almost average, driven by refundings because rates are lower and some schools have already gotten [bond referendums] through. But you are talking about bonds that have to be voted on, and I'm not that certain whether that's going to happen."

Detroit's problems radiate across the region, where many municipalities are already suffering their own problems, according to Alandt.

"Is this going to have a ripple effect? Yes - on a number of municipalities," he said. "There could be other municipalities that are going to be in the same straits as Detroit because of the lack of jobs, and as property values decline, tax collections are not as great and state aid is down. There's only so much the state can do to help out Detroit and other municipalities."

After years of planning for growth, some municipal experts are predicting that Detroit and other governments are going to have to figure out how to deal with shrinking populations and tax bases, Alandt said.

"Now that we're losing jobs and populations, what do we do with those infrastructures, for example the sewer systems, that may not be in use - do you plug them up with cement? Issue bonds to finance the reverse of growth?" Alandt said. "What is going to happen with [Downtown Development Authority revenue] bonds and TIF bonds? Those were all intended for tax breaks because the breaks would bring in this growth, but the growth is not coming."

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