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Discrete Dynamics in Nature and Society
Volume 2010, Article ID 950413, 52 pages
Research Article

Subprime Risk and Insurance with Regret

Faculty of Commerce, North-West University (Mafikeng Campus), Private Bag X2046, Mmabatho 2735, South Africa

Received 6 November 2009; Revised 4 August 2010; Accepted 24 November 2010

Academic Editor: Carlo Piccardi

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.