A person who is allowed to place bets which he might not be able to cover will, as a result of such ability, be able to achieve a higher payoff expectation than someone without that ability. In some cases, a such person may be able to combine multiple negative-expectation bets in such a way as to have a net positive outcome for the person placing them (and a huge negative outcome for someone else who will be left holding the bag).
I don't think companies that issued credit default swaps far in excess of their net worth failed to understand the dangers of correlated risks. More likely, they understood that the optimal way to monetize their ability to place bets they couldn't cover is to concentrate all the risk into one negative outcome, so all other outcomes would be positive. If the most one would stand to actually lose would be $10M, having a 1/1000 chance of being "obligated" (but unable) to pay $1B dollars is less "risky" than a 1/100 chance of having to pay $10M even though the former "expectation" is $1M and the latter expectation is only $100K. Accepting the latter risk in exchange for $80K cash would be a losing proposition, but "accepting" the former for $50K would be a winning proposition (since it really represents a 1/1000 chance of losing not $1B, but only $10M).
If one couldn't avoid one's obligations to pay, accepting $50K for a promise to make a 1B payment for a 1/1000 event would be a grossly losing proposition. On the other hand, if one isn't going to be paying anyhow, any premium one gets beyond what would be required to justify one's actual risk exposure is pure gravy.
That could certainly be an explanation of what was going on in the CDS market.
One reason that the CDS market was able to develop the way that it did appears to be due to the Commodity Futures Modernization Act of 2000 which left it mostly free of any oversight.
But there was also a well documented disregard of risk in some firms unrelated to swaps. The mortgage part of their business was where their profit was coming from and they didn’t want to hear anything negative about it. If their risk officers understood how exposed they were no one wanted to listen.