The recent subprime mortgage crisis has closed the doors to American homes and hedge funds alike. The most commonly cited explanation for this is that an unforeseeable collapse in home prices forced homeowners to refinance their adjustable-rate mortgages at unrealistic rates, resulting in payment delinquency and outright default.

In a world of dizzying financial complexity, this explanation fails to address the numerous agents whose alleged irresponsibility and apparent greed set the stage for this fiasco. Mortgage borrowers, mortgage lenders, investment banks, credit rating agencies, and hedge funds all share the blame for this financial crisis.

To understand the role these investors and institutions have played requires an understanding of the path mortgages follow from borrow to investor. During the housing market boom that peaked in 2005, with home prices purportedly guaranteed to rise, more homeowners developed an interest in purchasing more expensive homes—with adjustable-rate mortgages—believing that they were riskless investment vehicles.

Imagine a Las Vegas janitor and his schoolteacher wife facing rising housing prices and therefore considering refinancing their mortgage. They seek advice from a mortgage broker whose commission derives solely from the size of the loan he can underwrite. Naturally, the mortgage broker insists that he can get the couple into a $1 million home, despite their combined $75,000 income with an adjustable rate mortgage.

More shamefully, at the broker’s persistent urging to exaggerate their income, the couple chooses to lie, claiming a baffling $300,000 combined income. The brokerage firm has a disincentive to check the couples’ income, and thus these inflated incomes become the basis for the new mortgage. On both sides, irresponsibility and dishonesty destine these mortgages for failure; regulating brokers to promote responsible lending is a necessity, as is educating borrowers on the financial implications of their loans.

As if to acknowledge the toxicity of the new mortgage, the broker then sells off this debt to investment banks, which collect mortgages in bulk, securitizing them as collateralized debt obligations (CDOs). These CDOs are packages of mortgage-backed bonds, securitized from pieces of mortgages. As such, they can contain varying qualities of mortgages, despite tranches—or divisions of CDOs—that are intended to rank based on risk. Rating agencies are also to blame, because they facilitate the bank’s sale of securities to institutional investors. Many funds are restricted to buying only the highest quality securities with a AAA rating. This motivates the banks to seek these AAA ratings for their CDOs from a rating agency.

Although there is no direct evidence that rating agencies purposefully overrate these bonds, the fact that the agencies’ customers are the very same banks who are trying to sell these dubious securities raises conflict-of-interest issues. These rating agencies are thus not independent, objective judges of quality. Regardless of whether accusations against them are valid, such lack of transparency and failure to rate these securities accurately leaves rating agencies on the hook.

Nearing their terminus, the bonds fall into the laps of yet another culpable party: hedge funds. The incentive structure of hedge funds depends on maximizing return each year—rather than lowering the riskiness of its portfolio or pursuing long-term growth, or even solvency. Thus, in many cases these funds snap up the purportedly AAA securities, leveraging their positions skyward, and happily taking high yields.

Hedge funds practice such risky behavior because there are effectively no consequences for them. If hedge funds have fewer than 100 investors, or investors worth at least $5 million each, they are exempt from the Securities Exchange Commission Act of 1934 and the Investment Company Act of 1940. By avoiding this legislation, hedge funds do not have reporting obligations or leverage limitations.

So who loses in this financial maze?

Without a doubt, the clients of hedge funds lose more than anyone, in nominal terms, since their investments are worthless when the fund collapses. However, it is hard to pity the imprudent investors of fledgling funds. As the past six months have revealed, the more serious loss is the effect on the entire real estate market and the world economy. Investors around the world are paying for this reckless behavior motivated by the unsupervised greed that courses through the veins of subprime lending.

Most disappointing of all is that no one in the entire process is blameless, including the homeowners. In signing the mortgages as financially responsible adults—albeit at the urging of greedy brokers—many of these borrowers lie about their income. Perhaps foreclosure then is the rightful resolution for those who took on loans that they had no prayer of repaying.

To be sure, the economy will recover, the housing market will surge again, and even the failed hedge funds will open another shop—whether they are regulated or not. What this debacle does offer, though, is an opportunity to understand a network of impropriety driven by greed. In this network, those who have demonstrably overstepped their bounds should be condemned in the ongoing investigations, so as to discourage these practices from continuing.

More importantly, all agents involved—from home borrowers to investment institutions to hedge fund clients—need to take their own initiative to perform due diligence. With a little more financial responsibility, these hopelessly overstretched home loans would never have defined a national and international financial crisis.

Jeffrey D. Nanney ‘10, a Crimson editorial editor, is an applied mathematics concentrator in Currier House.