DETROIT (Reuters) - A U.S. bankruptcy judge on Thursday rejected a deal allowing Detroit to end costly interest-rate swap agreements with two investment banks, possibly further delaying when the city will submit to the court its plan to adjust its debt.
Ending swaps agreements with UBS AG and Bank of America Corp's Merrill Lynch Capital Services for $165 million - a 43 percent discount - has been a key component of Detroit emergency manager Kevyn Orr's plan to adjust the city's finances through the bankruptcy process.
Judge Steven Rhodes, who is overseeing the city's historic bankruptcy, said Detroit likely could succeed with potential challenges to the validity of the swaps agreements. The $165 million cost of eliminating the swaps was "too high a price to pay," Rhodes said.
Despite rejecting the deal, Rhodes said that settling the swaps deal for less is more advantageous than litigating the claims. Rhodes said he "strongly encourages the parties to continue to negotiate" even if the city decides that filing suit is its best option.
The swaps were used to hedge interest-rate risk for some of the $1.4 billion of pension debt the city sold in 2005 and 2006.
Detroit had planned to finance the swaps termination through a $285 million loan from Barclays Plc, but the judge denied the city's request to borrow that sum. Detroit could, however, still borrow $120 million to improve services, Rhodes ruled.
The $285 million loan from Barclays had been contingent on Detroit's pledging funds from the city's casino tax as collateral, but those funds are pledged as security on the original swaps agreements with UBS and Merrill Lynch.
It was not immediately clear if Barclays would be willing to provide the $120 million loan to help Detroit cover the cost of city services.
Representatives of UBS and Bank of America declined to comment on the judge's ruling. Orr's spokesman, Bill Nowling, did not immediately respond to a request for comment.
Robert Gordon, lawyer for the city's pension funds, said Detroit's planned payment to UBS and Merrill essentially treated them as secured creditors. "Paying them close to whole dollars was just far too rich," Gordon said.
Detroit's pension funds, bond insurers, banks and others opposed the termination deal. The objectors argued that the city should not have settled with the banks because it had convincing legal arguments to completely terminate the swaps.
But Orr, who has been running Detroit since March, testified in court that the city had only a 50-50 shot of winning the litigation, and he did not want to risk expensive legal proceedings or losing access to casino tax revenue, which was used as a lien in the swaps. The casino tax accounts for about 20 percent of the city budget, Orr has said.
The deal Rhodes rejected was the city's second such agreement with its swaps counterparties. Detroit originally had proposed a deal with Merrill and UBS in which the city would have ended the swaps at 75 cents on the dollar with a $230 million payment, but in a December hearing Rhodes called on the city to negotiate more favorable terms.
Detroit reached the new agreement with the banks after two days of mediation in late December.
Orr testified in court earlier this month that Detroit initially proposed a termination fee of $145 million to $150 million but that the investment banks would not agree to anything less than $165 million.
The swaps deal is one of the obstacles the city has sought to clear away so Orr can submit a proposal to the court on how Detroit plans to deal with its more than $18 billion in debt.
Meanwhile, mediation efforts have begun to bear fruit, with philanthropic foundations connected to Detroit pledging $330 million to help the city. In addition, Governor Rick Snyder is preparing to propose $350 million of support, over 20 years, to help protect worker pensions and prevent the Detroit Institute of Arts collection from being sold, according to reports on Thursday in the Detroit Free Press and elsewhere.
Orr had said he was going to submit the plan to the court in the first week of January, but that was delayed until the swaps were settled and other mediation efforts played out, Orr's spokesman, Nowling, said in an email last week.
"If it looks like mediation efforts are bearing fruit, it could push back the release date as we look to include any mediated agreements in the plan," Nowling said.
(Reporting By Joseph Lichterman, writing by Karen Pierog; Editing by David Greising, Chris Reese and Steve Orlofsky)