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Detroit bankruptcy plan faces widespread backlash

The road back for Detroit seems to be getting longer.

More than seven months after its historic bankruptcy filing, city officials Friday offered up their proposed plan to pay bondholders, pensioners and other creditors substantially less than the $18 billion in debt they're owed.

"We think the plan is reasonable," Emergency Manager Kevyn Orr told reporters. "We really don't have time for a lot of acrimony and litigation."

Kevyn Orr
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Kevyn Orr

But even before Orr had a chance to formally unveil it, the plan was under heavy attack from investors, unions representing city workers and other creditors. Their response indicates that the city's blueprint for recovery marks the start of the kind of litigious, acrimonious battle that Orr and other city officials are hoping to avoid.

Among those targeted in the 120-page "plan of adjustment" covering more than 100,000 creditors, the city's 24,000 retirees are among the most vocally opposed. Orr proposed 34 percent cuts to the pension checks of general city retirees and a 10 percent cut for police and fire retirees. Those cuts could be reduced if the city's two independent pension boards agree to the plan.

But the proposal drew little support from union leaders, including AFSCME Council 25 President Al Garrett, who called the plan "a gut punch to Detroit city workers and retirees."

"Retires cannot survive these huge cuts to the pensions they earned," he said in a statement. "The plan is unfair and unacceptable. We will continue our efforts in the courts and through negotiations."

Some bondholders would take an even bigger haircut, under the terms proposed Friday. While secured bondholders would get all of what they're owed, those holding unsecured, so-called general obligation bonds would get just 20 cents on the dollar.

(Read more: Detroit's next bankruptcy battle: Who foots the bill?)

Detroit bondholders may not be the only ones hurt by Orr's proposal. If the final plan pays Detroit investors less than 100 cents on the dollar, the impact could reverberate throughout the nearly $4 trillion municipal bond market, according to Robert Miller, who manages a municipal bond fund at Wells Fargo.

"You would have introduced a level of risk to a class of bonds that is not priced into the market," he said. "No matter how remote that risk may be, it is nevertheless present and investors will demand (higher interest rates) for assuming the risk."

Investors directly in the line of fire made clear Friday they were braced for a legal battle. Financial Guaranty Insurance Co. and Syncora, two companies that insure Detroit's general obligation bonds, were quick to denounce the plan. Together, they represent the second-largest class of creditors after retirees.

"While we understand that favoring pensioners and discriminating against bondholders and other creditors might be politically popular, we believe this is contrary to bankruptcy law and will result in costly litigation that will hamper the City's emergence from bankruptcy," said Steve Spencer, a financial advisor to FGIC, in a statement. "This will restrict the city's ability to fund the reinvestment essential to its revitalization."

That revitalization is a major goal of Orr's plan, which calls for spending more than $500 million for blight removal and investing another $1 billion to improve city services.

(Read more: Thinning blue line: Police cuts cripple cities)

"There are 700,000 residents who deserve an adequate level of services," said Orr.

But until the city can stabilize its finances, those residents continue to suffer. Some 20 percent of the city's housing stock is blighted or abandoned. Arson and other fires at those abandoned buildings produce 60 percent of calls to the Fire Department.

With the city's health-care resource in decline, some two-thirds of emergency medical services calls are for non-urgent treatment unavailable elsewhere, Orr told reporters.

The city's plan also includes $350 million in new borrowing to help pay for operating expenses. But that deal was contingent on the city terminating a series of money-losing interest rate swaps with UBS and Merrill Lynch.

A deal to pay off those swaps was rejected twice by U.S. Bankruptcy Judge Steven Rhodes as too generous. A third agreement has been reached in principal and details are expected to be made public next week.

The next step in the city's long road back is approval from Rhodes, who must confirm the plan. But Orr and his attorneys will first have to overcome a basic tenet of bankruptcy law that is supposed to treat all creditors equally.

Because bondholders are being asked to take a much bigger haircut than retirees, the plan doesn't seem to adhere to the so-called absolute priority rule that holds, in effect, that every creditor with equal standing gets a fair shake, according to George South III, a bankruptcy lawyer with DLA Piper.

"If the plan is going to give different treatment to similarly situated creditors then arguably that's not permitted," he said.

(Read more: The new city economy)

Rhodes isn't the only one Orr will have to win over if his plan has any chance of succeeding. The proposal also calls for $350 million in state funding to reduce pension cuts and spin off the Detroit Institute of Arts and prevent the sale of an art collection valued as high as $867 million. Some creditors argue that the art should be sold and the proceeds applied to debt payments.

That means convincing a skeptical legislature that Michigan taxpayers should help bail out the state's largest and most financially troubled city.

"A lot of people outside Detroit believe the city gets too much money from the state already," said Eric Scorsone, a Michigan State University professor who is following the Detroit bankruptcy. "So it's not going to be an easy sell. If that falls apart then this whole deal likely doesn't hold up as a realistic plan."

By CNBC's John Schoen. Follow him on Twitter @johnwschoen or email him.