(Adds comments from city's emergency manager)
By Cherie Curry
DETROIT, April 11 (Reuters) - Detroit's plan to get out of bankruptcy cleared a major hurdle on Friday when a U.S. Bankruptcy Court judge approved the cash-strapped city's third attempt at settling costly interest-rate swap agreements with two investment banks.
The city will pay $85 million to UBS AG and Bank of America unit Merrill Lynch Capital Services, much less than had been proposed on two previous attempts.
The banks join a growing list of supporters for Detroit's plan to adjust $18 billion of debt and other obligations.
With this deal in place, along with a recent settlement with three bond insurers, the city now has more supporters among key creditors to exit bankruptcy, even if it faces opposition from other creditors, including the city's labor unions and pension funds.
Kevyn Orr, the city's state-appointed emergency manager filed the biggest municipal bankruptcy in U.S. history in July as the city grappled with a huge debt load and fears that the banks could demand a big payment to terminate the swap agreements.
In his bench ruling, Judge Steven Rhodes warned creditors fighting the plan that the city may now be eligible for a so-called cramdown judgment in which the court could confirm the plan without any further agreements by creditors.
"The message is that now is the time to negotiate, not on the eve of the confirmation hearing in July, nor even in June or in May, but now," Rhodes said.
Orr, who has said he hopes to have the bankruptcy wrapped up by Oct. 15, also urged creditors to get on board.
"I reiterate Judge Rhodes's request that all parties negotiate and reach resolutions," Orr said in a statement. "We don't have the luxury of time - the offers on the table are grounded in reality and they won't last forever."
The judge, who rejected two previous proposed swap settlements as too expensive for the broke city, said the new deal is "entirely reasonable." Orr said Detroit had been facing an approximately $288 million termination payment and that the court-approved settlement will save the city about $200 million.
The swaps were used to hedge interest-rate risk on some of the $1.45 billion of pension debt Detroit sold in 2005 and 2006. However, the city's bet that interest rates would rise proved wrong as rates fell along with the city's bond ratings, souring the deal.
The previous settlements rejected by the judge had been much higher, at $230 million and $165 million.
On Wednesday, Detroit said it had reached a settlement with three bond insurers over the treatment of voter-approved general obligation bonds. As part of that settlement, the insurers agreed to vote in support of the city's debt adjustment plan as well.
Rounding up support for the restructuring plan from the banks and insurers could ultimately ease the way for the city to exit bankruptcy. If enough creditors approve the plan, then Detroit could force its terms on the creditors who object to it.
In an interview with Reuters on Wednesday, Orr said a cramdown would risk the loss of $816 million pledged by philanthropic foundations and the state of Michigan to ease retiree pension cuts.
Rhodes concluded that objections by bond insurer Syncora Guarantee, European banks that own some of the pension debt, the city's retired workers, and others lacked merit. Syncora and fellow bond insurer FGIC, along with the retirees committee, declined to comment on the ruling on Friday.
Those objecting had said the investment banks would fare better than Detroit's other creditors who face steeper losses in the bankruptcy case. Creditors also questioned the legality of a lien on casino tax revenue that Detroit granted to the banks in 2009 to stop them from forcing the city to pay as much as $400 million to end the swaps.
Rhodes said while there was a possibility Detroit could recover as much as $400 million by suing the banks, it was uncertain if the litigation would be successful.
Detroit will pay the $85 million to the banks over time, freeing up the casino revenue for critical city operations.
The city's labor unions, pension funds, and a court-appointed retirees' committee, along with bondholders, bond insurers, two Michigan counties and many other creditors filed a slew of objections on Monday to the revised plan Detroit sent to the court on March 31.
The objections to the amended disclosure statement, which is the key supporting document for the plan, said it was missing crucial details needed by creditors to help them decide how to vote on the plan.
The city has until Monday to try to resolve the objections ahead of a Thursday court hearing. (Reporting by Cherie Curry Additional reporting by Karen Pierog in Chicago and Lisa Lambert in Washington; Editing by Barbara Goldberg, James Dalgleish and Jonathan Oatis)