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Detroit bankruptcy to enter critical phase

Tuesday, 18 Feb 2014 | 4:14 PM ET

The historic Detroit bankruptcy case moves into a crucial and contentious phase with the expected filing this week of the city's so-called plan of adjustment. That is the city's plan to settle with its creditors and emerge from America's largest-ever municipal bankruptcy.

The plan has implications not only for Detroit, which is struggling under some $18 billion in unfunded liabilities, but also for Wall Street, and the $4 trillion municipal bond market—which had been considered one of the safest investments around.

(Read more: Detroit turns bankruptcy into Wall St. vs. Main St.)

A draft of the plan, which Detroit Emergency Manager Kevyn Orr circulated among creditors last month, reportedly gives a slight preference to the city's pension funds—which have fought tooth and nail against the bankruptcy—over its bondholders. But neither side is likely to come away happy. The pension funds reportedly would receive 25 cents for every dollar they are underfunded, while bondholders would reportedly receive 22 cents on the dollar.

Detroit street scene, February 2014.
Justin Solomon | CNBC
Detroit street scene, February 2014.

Those reports raised eyebrows among municipal bond investors, not just because of the perceived safety of municipal bonds, but also because Orr had pledged early on to treat the pensioners and bondholders equally, as so-called unsecured creditors.

One reason the pensioners could do slightly better is an $800 million aid package, worked out in confidential mediation sessions, aimed at shoring up the pension plans while protecting they city-owned collection at the Detroit Institute of Arts. The package includes contributions from the state, private foundations and a fundraising campaign by the museum.

The plan of adjustment is likely to include more information about the city's plans for the art collection. A city-commissioned appraisal by Christie's valued the art at around $800 million, but some creditors have argued the collection is worth billions and should be sold off.

(Read more: Detroit and retirees reach health coverage deal)

The plan to be filed this week is not by any means the final word on Detroit's restructuring. It is likely to be the subject of numerous legal challenges and wrangling among the city's hundreds of creditors for the largest possible piece of the pie.

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Among the issues still to be worked out are the size of the city's pension debt. Orr initially said the plans were underfunded by $3.5 billion, but the amount the city owes the funds as well as the rate of return used to calculate the pensions have all been topics in the confidential mediation sessions.

Also unclear is how the plan will address $1.4 billion in so-called swaps contracts sold to the city in 2005 and 2006 by UBS and Bank of America/Merrill Lynch, which the city now contends may have been illegal.

The swaps, which were backed by revenues from the city's casinos, allowed the city to skirt borrowing caps to fund its pensions. But when interest rates declined, the city found itself making payments it might not otherwise have had to.

The judge in the bankruptcy case, Steven Rhodes, earlier rejected an agreement that would have allowed the city to terminate the swaps for $165 million, and then borrow additional funds to finance the city's operations during the bankruptcy process.

At the same time the city files its plan of adjustment, it is also expected to file what is known as a "disclosure statement" detailing how the city will operate during the reorganization.

(Read more: Ex-Detroit mayor's legal bill to public: $813,806)

Orr has said he hopes the city can emerge from bankruptcy later this year.

—By CNBC's Scott Cohn. Follow him on Twitter @ScottCohnCNBC