The question is quite complex and an answer should be far beyond looking only at the structure of the derivatives, but i try my best.
The initial situation:
- Between 1998 and 2006, the price of the typical American house increased by 124%
- Global saving glut due to the dotcom-bubble in the early 2000s, seeking institutions for alternative investments, cutting out financial risks
- The Community Reinvestment Act which helped low- and moderate-income Americans to get mortgage loans
These points led to a situation, where in fact everyone could get a mortgage to buy a house, not only for using them as own-property, but as a financial asset. Also people with "no income, no job, no assets", leading to the term Ninja-Loan, were granted loans and mortgages. Times were great, as long as house prices increased. The US financial markets were flood by money from investors, wanting to become part of that upswing. How they took part, answers how the derivatives look like, and how their structure led to the financial crisis:
CDOs and CDSs
Lets take a look an a classic CDO:
CDOs pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of mortgage loans. There are several tranches, which catch the cash flow of interest and principal payments in sequence based on seniority.
As CDOs became popular, some investment banks repackaged selected tranches into yet another iteration, known as CDO-squared, a complex and intransparent structure of financial derivative.
A CDS (credit default swap) is a financial agreement that the seller of the CDS will compensate the buyer in the event of a loan default. It can be considered as an insurance for a creditor of the referenced loan.
Synthetic CDOs are CDOs, which do not only bundle the mortgage loans in the picture above, but also other assets and derivatives. Up to 2008 it was popular to construct CDOs, bundling single CDSs, rather then mortgage loans. This is the structure of a synthetic CDO, created in times before 2008.
How did defaults of mortgages hit investors twenty fold?
Synthetic CDOs described above can be considered as a bet on the performance of CDSs, rather than the performance on a real mortgage security. In fact, the derivatives were detached from a single mortgage due to repeated securization in CDOs and there use as an underlying for CDSs. They became solid derivatives offering high returns.
As stated in the New York Times (1), from 2005 through 2007, at least $108 billion synthetic CDOs were issued, but the actual volume can be much higher because synthetic CDO trades were unregulated.
Debate and further topics
Synthetic CDOs are well known for their destructive character during the financial crisis. They were easy to construct, barely supervised or regulated and offered high returns. As the former Citigroup CEO said, referring to the leveraged lending practice: "As long as the music is playing, you’ve got to get up and dance. We're still dancing." As long as there was a market for these derivatives, they were constructed. Current research address the missing incentives for each, buyer and seller of CDOs, CDSs and synthetic CDOs during the time before the financial crisis: As long as the risks of defaulting mortgages could be transfered to other parties, the credit-worthiness of a borrower does not matter any more. Furthermore, speculatives without any real insurable interest could invest in these derivatives, which increased the demand for these derivatives additionally.
For further information to the structure of the derivatives mentioned above see here or (2). On the role of rating agencies see (3).
(1): The New York Times, Banks Bundled Bad Debt, Bet Against It and Won, by Gretchen Morgenson and Louise Story, Published: December 23, 2009
(2) Joseph R. Mason, Josh Rosner: Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, May 14, 2007
(3): Markus K. Brunnermeier, DECIPHERING THE LIQUIDITY AND CREDIT CRUNCH 2007-08, NBER Working Paper No. 14612.