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Detroit reaches new swaps settlement with banks

Hoping the third time's the charm, the bankrupt city of Detroit says it has reached a tentative, $85 million deal to settle so-called "swaps" contracts with UBS AG and Bank of America Merrill Lynch, after previous agreements were deemed too expensive. The $1.45 billion contracts, which had allowed the city to sidestep borrowing restrictions to shore up its pension plans, have been a key sticking point in the bankruptcy.

The announcement was made by city Emergency Manager Kevyn Orr, who said the proposed agreement will be filed in court "in the coming days."

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"We appreciate the banks' willingness to work with us to reach a solution that we think balances our goal to provide realistic recoveries to creditors while freeing up critical funds that we can invest to improve the quality of life in Detroit," Orr said in a statement Monday.

The proposed settlement is half of what the city had proposed to pay the banks as recently as January. But U.S. Bankruptcy Judge Steven Rhodes rejected the $165 million settlement as too costly, saying the swaps contracts could be challenged in court as illegal, allowing the city to pay nothing at all.

Under the original terms of the swaps, the city would have been forced to pay $286 million, so Orr is portraying the latest agreement as a savings to Detroit's taxpayers of approximately $201 million.

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The city entered into the agreements in 2005 and 2006 in hopes of reducing its pension liabilities and locking in a fixed interest rate. The bets backfired when interest rates fell. Then in 2009 when Detroit's credit rating was reduced to junk, the city agreed to back the bonds with revenue from its three casinos—satisfying the banks, but denying itself a key source of funds. Many say the swaps were major culprits in Detroit's historic bankruptcy filing last year.

Under the proposed agreement, Orr says, the banks would relinquish their claims on the casino revenues. The city, in turn, would give up its right to sue the banks.

Under the deal, the banks also agree to vote in favor of Orr's "Plan of Adjustment"—the road map for restructuring the city's finances. The support is critical, since under federal bankruptcy law, a judge can approve such a plan as long as any one class of creditors votes in favor of it—even if others oppose it. That means Orr has new leverage as he pushes a plan that remains deeply unpopular with the city's unions, retirees and municipal bondholders.

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"We hope the swaps resolution serves as a model of compromise on other matters related to Detroit's finances," Orr said.

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