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In 2006, synthetic CDO issuance jumped from $15 billion in 2005 to $61 billion, with synthetics becoming the dominant form of CDOs in the United States. By year end, the synthetic CDO market was valued "notionally" at $5 trillion according to industry estimates. This explosive growth represented a dangerous amplification of risk in the housing market, as synthetic CDOs allowed Wall Street to create unlimited bets on the same underlying pool of mortgage debt through credit default swaps—essentially creating phantom exposure far exceeding the actual mortgages in existence.
While approximately $1.2 trillion in subprime loans existed in 2006, journalist Gregory Zuckerman estimated that more than $5 trillion of investments in synthetic CDOs were created based on these loans—a 4-to-1 leverage ratio. The structure allowed mortgage bonds to be "referenced" by an infinite number of synthetic CDOs, meaning the same pool of failing mortgages could trigger cascading losses across multiple layers of derivatives. Global CDO issuance across all types reached $551.7 billion in 2006, up from $157.4 billion in 2004, with much of the growth driven by synthetic structures.
Major Wall Street firms—particularly Goldman Sachs, Deutsche Bank, Morgan Stanley, and JPMorgan—were the primary creators of synthetic CDOs while simultaneously taking short positions in the securities. This created severe conflicts of interest, as banks earned fees for creating and selling synthetic CDOs to clients while betting against those same securities for their own accounts. Rating agencies compounded the problem by assigning AAA ratings to synthetic CDO tranches despite their extreme complexity and exposure to subprime mortgages. Internal S&P communications from 2006 acknowledged the agency was creating "an even bigger monster—the CDO market" with one analyst writing: "Let's hope we are all wealthy and retired by the time this house of cards falters." The synthetic CDO explosion in 2006 transformed a serious housing crisis into a global financial catastrophe, as losses were magnified exponentially through derivatives layers while regulators remained willfully blind to the systemic risk being manufactured.