The banks would take a big pile of these bad loans/debts, and "securitize" them, which basically means sell them like any other product. Their value is "backed" by mortgages and e payments owed, hence they are Mortgage Backed Securities (MBS). Within a MBS there are different levels or "tranches" you can invest in wth varying risk/reward. The investment banks would sell these to people, again taking on their fees and not worrying. A collateralized debt obligation (CDO) is the same thing, except it's a basket of different MBS's. The idea being that it looks more diversified because it's not on one security or MBS. The problem is, if your CDO is all MBS's they all have the same exposure. It's like saying, "I was going to invest in an orange grove in Florida but I'm worried about the risk of a storm, so I'll invest in 5 orange groves next to each other to 'diversify' my risk."

By securtizing these bad loans into junk bond, MBS's, etc., their risk was transferred to anyone who held the MBS's and the impact was felt accordingly.