Subprime risk and insurance with regret

Abstract

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