By Deepa Seetharaman and Rachel Jackson
DETROIT, Feb 19 (Reuters) - A federal judge on Wednesday gave Detroit and a group of bond insurance companies two or three weeks to settle a dispute over whether the city can treat certain bonds as unsecured debt, warning of an "all or nothing" ruling if no deal is reached.
The outcome of the dispute could significantly affect the $3.7 trillion municipal bond market, where general obligation bonds backed by the full faith and credit pledge of cities, school districts and others has long been considered sacrosanct.
If the general obligation debt in question is ruled to be unsecured debt in this case, as Detroit's lawyers argue, it could result in investors demanding higher premiums to lend to the city and other local governments in Michigan.
Detroit, which filed for bankruptcy in July, defaulted on the voter-approved general obligation bonds in October, prompting three bond insurance companies that were on the hook to make up the payments to sue the city.
After hours of testimony, Judge Steven Rhodes encouraged the parties to mediate their differences in the coming weeks. Should they fail to do that, he said he would be forced to make a ruling in favor of one party or the other.
"One side is going to win and the other side is going to lose," Rhodes said of such a scenario.
His comments followed an exhaustive, day-long debate between the two sides that dug deep into issues ranging from verb tense to a 19th century American law.
Rhodes formally declared Detroit bankrupt in December, clearing the way for potentially sweeping cuts for worker pensions and bondholders, and ordered the city to present a blueprint for how it will treat some $18 billion of debt.
Lawyers for the city said Wednesday that Detroit hoped to file that blueprint - known as a plan of adjustment - this week.
The outcome of the bond dispute is likely to turn on the definition of the word "pledge." Rhodes has to determine whether a pledge of Detroit property tax revenue to pay off the voter-approved bonds, which totaled about $410 million at the end of the city's fiscal 2012, is a binding obligation under Michigan law, as argued by bond insurers in two lawsuits, or merely a promise.
"These are not simple promises that the city made to its bondholders. These are requirements made under state law," said attorney Guy Neal of Sidley Austin, one of the team of six lawyers representing bond insurance companies National Public Finance Guarantee Corp, the public finance subsidiary of MBIA Inc, Assured Guaranty Municipal Corp, and Ambac Assurance Corp.
Caroline English, an attorney for Ambac, cited a 126-year-old case to support her argument that voter-approved taxes levied to pay the bondholders cannot be diverted to other uses.
But the many theories involving the meaning of words such as "lien" and "pledge" when applied to bonds seemed to irk Rhodes.
"It's now clear to me that my earlier count of your theories underestimated the number. I think you're up to eight now," he said at one point.
Detroit has asked the judge to dismiss the lawsuits.
Earlier in the hearing, Robert Hertzberg, a partner at law firm Pepper Hamilton who is representing Detroit, told Rhodes the city will present a third attempt to settle costly interest-rate swaps in the next three or four days.
That could free up money to fund city improvements.
Rhodes, however, has already rejected two prior settlement proposals with swap counterparties UBS AG and Merrill Lynch Capital Services, calling them too costly.
The swap agreements were meant to hedge interest rate risk on some of the $1.45 billion of pension debt Detroit sold in 2005 and 2006. But the swaps, valued at $400 million in 2011, soured as interest rates dropped along with Detroit's credit ratings. The money owed the banks was a key element that drove the city to file for Chapter 9 municipal bankruptcy in July.
Detroit filed a lawsuit on Jan. 31 in U.S. bankruptcy court seeking to invalidate the pension debt, a move that could also void the swaps.
Rhodes also said he would soon issue a written opinion about the need for an unsecured creditors committee created in December that includes the city's two pension systems -- its biggest unsecured creditors -- and bond insurer Financial Guaranty Insurance Co.
Detroit's attorneys argued that all of the city's major unsecured creditors have already participated in the case, including mediation, and have legal representation.
Rhode grilled lawyers for the committee and questioned whether it was cost-effective.
"We've got to control costs. Everybody has to add value to the case. Where's your value?," he asked one lawyer.
A separate committee formed at the city's request earlier in the bankruptcy case to represent retired city workers cost Detroit nearly $2 million in fees and $61,500 in expenses between July and September, according to a report released this month by a court-appointed fee examiner.