This is the default behavior for SSH. It protects user keys by enforcing rwx------ on $HOME/.ssh and ensuring only the owner has write permissions to $HOME. If a user other than the respective owner has write permission on the $HOME directory, they could maliciously modify the permissions on $HOME/.ssh, potentially hijacking the user keys, known_hosts, or something similar. In summary, the following permissions on $HOME will be sufficient for SSH to work.
- rwx------
- rwxr-x---
- rwxr-xr-x
SSH will not work correctly and will send warnings to the log facilities if any variation of g+w or o+w exists on the $HOME directory. However, the administrator can override this behavior by defining StrictModes no in the sshd_config (or similar) configuration file, though it should be clear that this is not recommended.