Faculty of Commerce, North-West University (Mafikeng Campus), Private Bag X2046, Mmabatho 2735, South Africa
Copyright © 2010 M. A. Petersen et al. This is an open access article distributed under the
Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.
This paper investigates some of the risk and insurance issues related to the subprime mortgage crisis. The discussion takes place in a discrete-time framework with a subprime investing bank
being considered to be regret and risk averse before and during the mortgage crisis, respectively.
In particular, we investigate the bank's investment choices related to risky subprime structured
mortgage products and riskless treasuries. We conclude that if the bank takes regret into account,
it will be exposed to higher risk when the difference between the expected returns on subprime
structured mortgage products and treasuries is small. However, there is low-risk exposure when this
difference is high. Furthermore, we assess how regret can influence the bank's view of a rate of return
guarantee from monoline insurers. We find that before the crisis, regret decreased the investment
bank's preparedness to forfeit on returns when its structured product portfolio was considered to
be safe. Alternatively, risk- and regret-averse banks forfeit the same returns when their structured
mortgage product portfolio is considered to be risky. We illustrate the aforementioned findings
about structured mortgage products and monoline insurance via appropriate examples.