Floyd Norris has an interesting piece discussing Citigroup's $7 billion settlement for misrepresenting the quality of the mortgages in the mortgage backed securities it marketed in the housing bubble. Norris notes that the bank had consultants who warned that many of the mortgages did not meet its standards and therefore should not have been included the securities.

Towards the end of the piece Norris comments:

"And it may well be true that actions like Citigroup’s were necessary for any bank that wanted to stay in what then appeared to be a highly profitable business. Imagine for a minute what would have happened in 2006 if Citigroup had listened to its consultants and canceled the offerings. To the mortgage companies making the loans, that might have simply marked Citigroup as uncooperative. The business would have gone to less scrupulous competitors."

This raises the question of what purpose is served by this sort of settlement. Undoubtedly Norris' statement is true. However, the market dynamic might be different if this settlement were different.

Based on the information Norris presents here, Citigroup's top management essentially knew that the bank was engaging in large-scale fraud by passing along billions of dollars worth of bad mortgages. If these people were now facing years of prison as a result of criminal prosecution then it may well affect how bank executives think about these situations in the future. While it will always be true that they do not want to turn away business, they would probably rather sacrifice some of their yearly bonus than risk spending a decade of their life behind bars. The fear of prision may even deter less scrupulous competitors. In that case, securitizing fraudulent mortgages might have been a marginal activity of little consequence for the economy.

Citigroup's settlement will not change the tradeoffs from what Citigroup's top management saw in 2006. As a result, in the future bankers are likely to make the same decisions that they did in 2006.

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