(FORTUNE Magazine) – IN GREEK TRAGEDY it's called anagnorisis, the climactic moment when the protagonist recognizes his fate, irreversibly changing the action of the drama. In the tragedy of Third World debt, that scene was played on May 19, when John Reed announced that Citicorp was adding a staggering $3 billion to its reserves against losses on loans to developing countries. The admission by the chairman of America's biggest bank that the loans are worth less than their face value was the first time in the five-year-old drama that a leading player had spoken the fearful, heretical truth. In the classical tradition, it was a move whose consequences reach well beyond the protagonist. Reed's declaration is echoing louder and farther every day. It has put other banks on the defensive, effectively challenging them to match Citi. A week after the announcement, Norwest Corp. of Minneapolis, the nation's 24th- largest bank, raised its reserves against Third World loans by $200 million, suffering a $160-million quarterly loss. The next day Chase Manhattan, No. 3, upped its reserves by $1.6 billion; it expects to report a loss of about $1.4 billion for the second quarter. Other dominoes are likely to fall soon, and banks weaker than Citi could get badly hurt, both the money center banks in New York, Chicago, and San Francisco and the large regionals like First Interstate in Los Angeles (it holds $1.5 billion of Third World debt) and Texas-based Republic Bank ($1.2 billion). That's just the beginning. Reed broke ranks with the restive bank syndicate that lends to troubled Third World debtors, mostly Latin America and the Philippines. Now the cartel could dissolve altogether, making loan renegotiations an all-but-impossible task. By preparing to recognize losses, Reed cut the value of a strong card -- the threat of default -- in the hands of debtor nations. He also braced Citi to absorb the losses that will come as the bank clears loans off its books by selling them into the secondary market, exchanging them for bonds issued by debtor governments, or swapping them for equity stakes in Third World companies. The Reed-inspired rush to reserve could even lead to higher U.S. interest rates in the short run, though it may create lower inflation and lower interest rates over time. The Federal Reserve would like to boost the falling dollar by tightening money and raising rates, which would lure foreigners to buy more dollars. But Fed Chairman Paul Volcker has avoided true tightening since the debt crisis began, out of fear that a collapse in Latin America could threaten the banking system. Now Volcker may realize he has more freedom than he imagined. Several developing nations, including Brazil, the largest debtor, have refused to pay the interest they owe. Although Citi has taken its big hit and other lenders are following suit, the banking system remains intact. Tighter money now should lead to lower inflation and interest rates in 1988 and beyond. Citi's move offers cold comfort to debtors, who still owe the full principal and interest on their borrowings. Reserving against possible losses makes it easier for the banks to forgive some loans or accept lower interest, but bankers still oppose granting such relief, at least in public. And in light of the reserves, it will be harder for bank directors to go along with any plan to make significant new loans to the Third World, including the scheme Treasury Secretary James Baker has been pushing. If commercial banks don't ante up, then government agencies like the World Bank and the International Monetary Fund may be forced to pick up the slack. Should outraged taxpayers refuse to foot the bills for agency loans, the debtor nations, from Mexico to Argentina, may grow more slowly than they otherwise would. That would threaten the parlous political stability of Latin America and blight prospects for increasing U.S. trade with the region. MAKING WAVES, even tidal ones, is entirely in character for the 48-year-old Reed. Known to the banking fraternity as ''the brat'' because of his relative youth, his impetuosity, and his irritating obsession with detail, he had reached the boiling point with the bank syndicate. Haggling for months with other bankers over fractions of a percentage point in the interest rates that debtor nations would pay had worn the chairman's patience as thin as . . . well, as a reed. Though he kept hoping for a painless exit from the debt problem, none materialized. Inaction finally became unacceptable. Asked to explain his decision, Reed points to a curious plaque on the credenza in his office. It bears a quotation from The Best and the Brightest, David Halberstam's tale of the U.S. entanglement in Vietnam: ''To say that what can't be easily measured doesn't really exist . . . is suicide.'' Reed finally took Halberstam to heart and measured the shakiness of Citi's $14.9 billion in Third World loans whose terms had been renegotiated. Clutching the plaque, he says of his bold action, ''There are risks here that are real and that must be provided for.'' Yes, but . . . the immediate impact on Citicorp is less than it appears. Shifting $3 billion from retained earnings to the reserve socked Citi with a $2.5-billion loss for the second quarter, the biggest quarterly bank loss in memory. Red ink for all of this year should come to $1 billion. Yet Reed did nothing that directly affects cash flow. Building reserves is just an accounting transaction that moves capital from stockholders' equity to another capital account. As Reed allows when pushed, the move strengthens the bank from a psychological point of view. The true reckoning will come later. Over the next three years, Reed plans to unload up to $5 billion of Third World loans by various means, all of them likely to bring in less than the face value of the loans. The difference will be charged against the reserve. Those charges won't affect future earnings -- Citi has already taken the earnings hit by setting up the reserve -- but they will reduce capital. Citi hopes to replenish capital by earning roughly $2 billion a year in 1988 and 1989. If it can't -- if, say, it has to set up even more reserves -- the bank may have to raise additional capital, sell off loans, or ask regulators to exempt it from minimum capital requirements. Yet investors lapped up Reed's reserving, pushing Citi's stock from $50.625 to $55.375 in the week following the announcement. Ironically it was Reed's predecessor, Walter Wriston, who helped get both banks and debtors in over their heads. With the siren song that sovereign debtors never go bankrupt, Wriston in the 1970s led the international banking community headlong into offshore lending. Flush with OPEC deposits, the banks were only too happy to lend the money. Now the 15 most troubled debtors owe foreigners $437 billion. U.S. banks hold $86 billion of those loans. Between the late 1970s and the early 1980s, soaring interest rates sextupled the annual interest burden on Third World countries. Paying that interest became doubly onerous because at least a third of the borrowed money left the countries as flight capital. In what University of Chicago Professor Larry Sjaastad has called ''the greatest rip-off of the 20th century,'' wealthy Latin Americans used much of the money to buy assets in places like Florida and New York instead of investing back home. As Latin American governments spewed the borrowed dollars into their economies, fat cats had no trouble exchanging fast-depreciating local currencies for the dollars they invested up north. The result: The debtor countries cannot afford to invest internally and service their debt. The only way they can pay Paul is by robbing Pedro. The drama formally began in 1982, when Mexico nearly defaulted on $82 billion in loans. Creditors met that threat by stretching out maturities and lowering interest rates -- the rescheduling ritual now enacted almost annually in countries throughout the Third World. In 1985, Peru's president, Alan Garcia Perez, declared his country would devote no more than 10% of its export earnings to servicing foreign debt. Peru has been paying interest on only a fraction of its loans ever since. Eager to count as profits the remaining $35 billion a year in interest due from other debtors, the banks have lent the countries enough money to keep the loans current, a ploy known as round- tripping. (The process is akin to a profligate's using his checking-account credit line to pay interest on his credit-card balance.) It was round-tripping that enabled the banks to keep shaky loans on their books at full value even though most debtors can't service them. In the past four years only Venezuela and Colombia have repaid any principal, and their payments have been modest. The stock market easily saw through the accounting chicanery. The price- earnings multiples of major U.S. banks have averaged only 40% of the P/E on Standard & Poor's 500-stock index. And rating agencies have downgraded most long-term bank paper. They couldn't ignore the hard evidence provided by the secondary market, where most Third World debt dumped by European and small U.S. banks trades at around 65% of face value. Mexico, having initiated the debt crisis, helped bring it to a head. Jose Angel Gurria, 36, Mexico's chief debt negotiator for the past five years, doubtless influenced Reed and others to bolster their reserves. Last year Gurria landed the most concessionary deal to date, a stretchout of $44 billion in existing loans, a new loan of almost $6 billion, and at least $250 million in annual interest savings. He also wangled two contingency plans from the banks. One will trigger another $500 million in new loans if Mexico fails to meet domestic growth targets; the second guarantees an extra $1.2 billion if exports fall below a certain level. ''Gurria is one of the best negotiators around,'' concedes Citicorp's restructuring chairman, William R. Rhodes, who sat across the table from him as point man for U.S. banks. Tough as it was bargaining with Gurria, Rhodes says that convincing U.S. regional banks to buy into the deal was even more grueling. Negotiating with Mexico took just over two months. Rhodes spent six months getting Mexico's 430 creditors to cough up the new money. Though some 60 banks ultimately walked / away, Rhodes united the rest by convincing them that new loans would make their old ones less risky. ''We're in there lending because we believe that the only way to get our money out is to put these countries on a stronger path,'' says a New York banker involved in the negotiations. Not so, argues Charles Coltman III, chief lending officer at Philadelphia National Bank: ''Piling debt on debt only beggars these nations to pay bankers interest.'' NEW BANK LENDING -- $20 billion over three years -- was the central pillar of the plan Secretary Baker unveiled in Seoul in 1985. His strategy was for banks to lend new money so that the developing countries could grow. In exchange, the debtors would make capitalist reforms like selling off nationalized industries and lowering barriers to investment. As FORTUNE predicted in December 1985, the initiative flopped. ''The Baker Plan is bankrupt,'' says Allan Meltzer, economics professor at Carnegie-Mellon University. ''Mexican debt trades for about 60 cents on the dollar. That means the new $6 billion the banks lent was worth $3.6 billion the next minute. The banks gave away $2.4 billion. Is that sensible?'' Most regional bankers never want to hear the words Buenos Aires again. But Rhodes hopes to bring them around with the innovative Argentinian refinancing package he cobbled together in April. ''To get the fence-sitters,'' says Rhodes, Argentina decided to pay a small bonus to banks that sign on by the end of June. Argentina also is offering a tantalizing bait called an exit bond. Instead of forking over its share of some $2 billion in new loans, each bank in the syndicate has the option of trading as much as $5 million of its existing loans for bonds, an amount that would cover the exposure of many regional banks. But since Argentina will pay only 4% interest on the bonds, they will be worth considerably less than face value. Indeed, they may be worth even less than the 60 cents on the dollar that banks can get by selling Argentine loans in the secondary market. Bankers won't know the answer until they accept exit bonds and then peddle them on the secondary market. The pressure to face reality and boost reserves became irresistible this spring. Brazil gave the screw another turn in February, when it stopped paying interest to private lenders (it still pays official creditors like the IMF and the World Bank). Says John G. Medlin Jr., C.E.O. of First Wachovia, a North Carolina bank: ''It must now be admitted that . . . contrary to one famous international banker ((read Wriston)), countries do default. It is now called a moratorium on payments.'' In the spirit that a good offense is the best defense, major banks responded by categorizing Brazilian loans as nonperforming, meaning they would credit interest payments to earnings only when they got the cash. The reclassification clobbered first-quarter profits. Among the worst hurt: Citicorp by roughly $50 million after taxes, BankAmerica by $40 million, and Morgan Guaranty by $20 million. Regulators normally allow banks to accrue interest for 90 days without actually receiving any. But bankers decided to forgo the Brazilian interest immediately rather than sweat out the three-month grace period at the country's mercy. Biting the bullet, they argued, would make them less vulnerable when they sit down at the rescheduling table with Brazil, probably in June. Setting up reserves against the loans is a similar, but much more drastic, move. THE STANDOFF between Brazil and its 750 creditor banks persists, even though a key machete holder has changed. In late April, Luiz Carlos Bresser Pereira replaced Dilson Funaro, the controversial finance minister who imposed the moratorium on interest payments. Pereira, who holds an M.B.A. from Michigan State University, swiftly devalued the cruzado by 8% to boost exports, giving anxious bankers some hope that he would be less confrontational than his predecessor. But with inflation surging toward 800% and exports still lagging, Brazil's prospects for resuming full debt service anytime soon are dismal. And Pereira may prove as tough as Funaro. In May the Brazilian press reported the finance ministry would extend the debt service moratorium to cover payments due to official creditors like the IMF. Pereira denied the reports. If Brazil becomes a permanent deadbeat, U.S. regulators will force the banks to reduce the book value of their Brazilian loans to an amount they can realistically recover. Reed feels his reserves are fat enough to absorb such a write-down: Citicorp's cushion against Third World debt now totals $3.5 billion, or about 26% of its questionable loans. Other banks are less smug, says Adam Starr, an analyst at the First Manhattan brokerage firm. ''A lot of the large banks are perturbed that Reed has painted them into a corner. They will all have to build up their reserves.'' Some can postpone the decision. Morgan Guaranty and Bankers Trust, analysts argue, have robust capital - positions that obviate the need to plump up their reserve cushions now. Shakier banks face real trouble. Replicating Reed's action would wipe out at least half the shareholders' equity of BankAmerica and a third or more of Manufacturers Hanover's, estimates Felice Gelman, an analyst at Fox-Pitt Kelton, a brokerage that specializes in bank stocks. Both banks might have to sell stock, unload assets, or trim dividends. BankAmerica is down to its last salable assets and has already stopped paying dividends. Selling stock when the bank is tottering will come dearly. In response to Reed's challenge, Chairman A. W. Clausen insists that BankAmerica's reserves are ''appropriate'' and that he is ''aware of no development'' that would require adjustments. Even so, Clausen says he is considering an addition to reserves because of market pressures. Manufacturers Hanover is loath to lower its hefty 8% dividend but says it is reviewing the situation ''intensely.'' Some bankers say privately that the Federal Reserve and other regulators were irked by Reed's action because it will help to push the weakest banks to the brink. Reed contends that's not true, citing the fact that he conferred at length with all the regulators in the weeks preceding the announcement. He waited to tell the competition, however, until he was about to tell the world. In the half hour between the board meeting that approved the action and the press conference that announced it, Reed and his deputies got on the horn to break the news to BankAmerica, Manufacturers Hanover, and others.

The reaction from Latin America was predictably circumspect. Some officials peppered their responses with tongue-in-cheek rhetoric -- and a dash of wishful thinking. Said Gurria of Mexico: ''The measure will allow the enlightened leadership of the bank to participate with more flexibility and calm in the debt negotiations.'' Brazil's Pereira asked his countrymen to believe that Reed's declaration ''does not alter Brazil's policies toward the foreign debt or its relations with Citicorp.'' Citicorp and its peers undoubtedly will approach the debt crisis more creatively now. For starters, they will dip more liberally into the menu of financing alternatives that banks have devised to reduce their loans. The most popular dish is one that clears debt off their books by swapping it for equity in businesses in the borrowing countries. Reed says so-called debt-equity swaps are the principal way he will unload up to $5 billion -- one-third of the bank's rescheduled Third World loans -- over the next three years. The model swap transaction goes like this: A foreign bank presents a loan to the borrowing country's central bank. The central bank pays off the loan at somewhat less than face value, and in the local currency, not dollars. The foreign bank then uses the local currency to buy assets in the debtor country. The foreign bank gets more money than it could by selling the loan in the secondary market; the country gets new investment that fosters growth, cancels some of its foreign debt, and reduces interest payments. Most big banks have avoided swapping their own loans for equity. The transactions entail losses, and bankers worry that just one losing swap might oblige them to write down the rest of their loans to the country involved. But banks have been happy to act as middlemen, helping multinational companies buy up loans in the secondary market and swap them for foreign investments. Because the borrowing countries pay more to buy in their loans than the companies have to spend in the secondary market, the companies get what amounts to a subsidized investment. Ford, Nissan, and McDonald's, to name but a few, have leaped at the cheap funds. In the past year Mexico received 190 requests to swap $1.65 billion of loans, or 1.7% of its debt; $700 million worth of deals have been completed. Chile, the most avid swapper, will have lopped 10% off its $16 billion in foreign bank debt by year's end. In the largest swap yet, Carter Holt Harvey, a New Zealand forest products company, bought $161 million in Chilean debt for $115 million and traded it for half of Copec, a natural-resource conglomerate that is among the largest companies in Chile. Attractive as they are, swaps alone can't end the debt crisis. Latin America just doesn't have enough investment opportunities. And U.S. companies and banks would feel skittish about making massive commitments in countries prone to nationalize assets when the government changes. Thus far Latin borrowers have reduced their debt burden by some $5 billion through swaps. The technique's most optimistic proponents say the market could expand to $10 billion a year -- but only for a few years. In all, swaps might wipe out 10% of Latin America's debt, or some $40 billion. Says T. Christopher Canavan, an analyst at Multinational Strategies, which assesses political and economic risks: ''Swaps are an effective marginal tool, not a panacea.'' Major U.S. banks -- including Citicorp -- continue to maintain that reschedulings, debt-equity swaps, exit bonds, and the like will solve the debt crisis, as long as the countries tighten their belts another few notches. The banks are deluding themselves. Debtor countries simply pay too great a percentage of export earnings to foreign creditors. A rule of thumb used by bankers and economists is that debt payments should not exceed half of export revenues. Anything above that jeopardizes a country's ability to finance imports and development. Brazil's payments are double that theoretical limit; Mexico's, 2.5 times; Argentina's, three times. The Third World could work harder at denationalizing industries, cutting budgets, and luring investment, as Baker has urged. But at this point the countries cannot afford enough investment to grow their way out of the debt problem. Since 1982 annual interest payments have eaten up as much as 6% of GNP in some countries. Debtor nations can't afford to import new machinery, refurbish industrial plants, open ports, or rebuild roads -- the minimal investments needed to get their economies humming. GIVING Latin America some elbow room probably is the only way to avoid debt repudiation -- the outcome bankers fear most. Says Jeffrey Sachs, a Harvard economics professor and an adviser to Bolivia: ''The question is not what will happen to Citicorp if it gives relief. Citicorp will survive. The real issue is that electricity doesn't work in Latin America, and wages are declining.'' Contrary to conventional wisdom, debtors do not rejoice in defaulting. Developing nations, including Peru, cannot afford to drop out of the mainstream for long because they depend on international financing to grow. It is in Latin America's best interest to maintain a working -- and workable -- relationship with the banks. Citicorp has distinguished itself by publicly acknowledging that its Third World portfolio is in trouble. But reserves -- even write-downs -- do nothing for debtors. Charles Coltman of Philadelphia National Bank has put forth a more creative, once-and-for-all solution to the debt crisis. He proposes that banks cut interest rates on existing debt below their own borrowing costs, giving Latin America a real breather. Banks that want to continue their relationships with debtor nations should lend new money only to finance trade, he says. New trade credits would have seniority over old debt, meaning that borrowers would pay those obligations before any other. ''Renewed trade financing would also help our clients who need to export to Latin America,'' Coltman says. That plan or something like it makes sense because trade financing to the Third World has nearly vanished. In the face of a $165-billion trade deficit this year, the U.S. can ill afford this development. Allan Mendelowitz, a high official at the General Accounting Office, estimates that since 1981 the debt crisis has increased the U.S. trade deficit by as much as $24 billion. And Wharton Econometrics says the problem has cost U.S. workers at least 400,000 jobs. Without a comprehensive solution like Coltman's, banks will stay caught in a web woven only in part by imprudent borrowing. Banks trapped themselves by emptying their pockets with their eyes wide open. Carl E. Reichardt, chairman of Wells Fargo, admitted as much in a moment of unguarded candor. At a gathering of California businessmen in January, a member of the audience asked, ''Did U.S. banks make those huge and troublesome loans to Third World countries largely because the government pressured them to do so, or was it greed for those high interest rates?'' Reichardt's response: ''You're all my friends here so I can level with you. It was the latter.'' That greed has come back to haunt the banks. First Wachovia's Medlin hit his colleagues between the eyes at a recent banking convention in Boca Raton, Florida. ''All of us made mistakes,'' he said. ''The larger banks lent too much, . . . and the small banks should have refrained entirely. A solution eventually will evolve that punishes those who ignored basic banking principles.'' The penance has begun.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: NO CAPTION DESCRIPTION: Foreign debt owed by each of Baker Plan countries.