John Reed was the Chairman of Citicorp during the mid-1980s. Among his many achievements was overseeing the first write-downs of loans to less developed countries. For this, he was put on the cover of the mainstream media weekly news and business magazines.
Why was this such a big deal?
Because until he publicly acknowledged that the value of the loans to less developed countries on Citicorp's balance sheet was not the 100 cents on the dollar they were carried at, but rather the 60 cents on the dollar that a Bloomberg terminal showed they traded for, financial regulators acted as if this valuation problem did not exist.
Financial regulators justified their cover-up by saying they were concerned that when the capital markets found out how bad the losses on the banks' balance sheets from loans to less developed countries were, it would spark a financial crisis.
As everyone who is familiar with the FDR Framework knows, stability in the financial system comes from market participants having all the useful, relevant information.
Instability in the financial system comes from regulators using their information monopoly to cover up a problem that the market knows exists, but in the absence of the useful, relevant information the market participants cannot quantify and price the risk.
A fundamental prediction of the FDR Framework, which has proven true for 75+ years, is that financial markets do not implode when market participants have access to all the useful, relevant information.
The corollary, which has also been proven true with the most recent credit crisis, is that financial markets do implode when market participants do not have access to all of the useful, relevant information.
It is a matter of fact that Citicorp's stock price went up significantly on the day John Reed announced the write-downs and for several days thereafter. It is also a matter of fact that the rest of the global banking system followed his lead and that they too saw their stock price increase.
In fact, with the issue of the valuation of the loans to the less developed countries addressed, many of the banks were able to tap the capital markets for more equity.
One of the financial firms that followed John Reed's lead was Security Pacific Corp, at the time a Fortune Top 10 US bank holding company. It had a significant portion of its loan portfolio concentrated in loans to less developed countries. In fact, had Security Pacific matched the percentage write-down taken by Citicorp, it would have had negative equity.
Did this fact cause a run on the bank at Security Pacific? No.
Did this fact cause Security Pacific's stock price to drop to zero? No.
Market participants understood that Security Pacific would need to rebuild its capital and factored that into the price and amount of their exposure to the bank holding company.
What does this have to do with Europe?
The situation in Europe is virtually the same as John Reed faced.
- A quick check of a Bloomberg terminal would show that like the loans to the less developed countries the debt of Greece, Ireland, Portugal and Spain are not trading at par.
- For their part, financial regulators are engaged in a cover-up. They are not a) disclosing each financial institutions' asset-level exposure or b) requiring financial institutions to write-down the value of their exposure to market prices.
- Governments where the lending financial institutions are located are working feverishly to promote austerity to try to keep the value of the debt at par.
- Market participants do not have the information they need to assess the risk of and properly price the securities of the financial institutions.