• Private equity -- with $1.3 trillion in buying power (e.g., equity plus access to debt), used borrowed money to take over public companies, extract fees, and sell them back to the public in IPOs or to corporate buyers.
• Hedge funds -- with $2 trillion under management, used leverage to engage in poorly disclosed quick trading strategies -- which despite their relatively poor returns were able to attract enormous pools of capital and hence massive fees.
• Mortgage finance -- a $10 trillion market, used the willingness of pension funds, hedge funds, and insurance companies to buy mortgage-backed securities (MBSs) to finance a massive housing boom. The high fees paid to the mortgage originators, investment banks which packaged and sold the MBSs, and the credit raters and mortgage insurers fueled the boom.

As I've noted, mortgage finance -- specifically subprime -- is collapsing now but private equity and hedge funds may have similar problems. The key commonality is that many of the participants are paid when they originate transactions and don't bear the cost of bad credit decisions which emerge long after the originators receive their fees.

Those with the weakest bargaining power bear those costs -- in the case of the mortgage industry, these include the borrowers who lose their homes to foreclosure, the mortgage originators' employees who get laid off after lending standards are tightened and volume drops off, and the small shareholders whose holdings tumbled.

Sunday's New York Times [registration required] suggested that NovaStar Financial, Inc. (NYSE: NFI) was paying off mortgage brokers to trick borrowers into taking on riskier, and higher yielding mortgages than they expected. In one typical loan, NovaStar paid $5,344 -- called a yield spread premium (YSP) -- to a mortgage broker whose job, the borrowers later learned, was to persuade them to take out a loan at a higher interest rate.

As part of a class action lawsuit, these borrowers discovered that NovaStar's policy was to hide the YSP from borrowers. How so? In 2003, NovaStar sent a flier to brokers that encouraged them to tap into NovaStar's capital -- its warehouse line -- and not to disclose the yield spread premium. It said: "Use Your NovaStar Warehouse Line and close in your name without disclosing YSP!"

Will society end up bearing the costs of such systematic deception? So far the cost of bailing out hedge fund collapses, such as the $6 billion Amaranth one, have been handled within the industry. But there's a danger that society will be left holding the bag for the mortgage and real estate implosion as its spillover effects rise.

I have noticed that global stocks are doing better in this environment so I am beginning to focus on them a bit more. One example, is Posco (NYSE: PKX), the Korean steel company which I picked in my newsletter whose stock rose 11% last month. With the S&P 500 flat for 2007, PKX's performance suggests better opportunities abroad.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in NovaStar or Posco.