Thanks for the post. It fills in facts where I had only had impressions. (The link in the OP sent me to a "subscriber only" WSJ page. I found a copy posted here: Australians Lose Millions In Bernie Madoff Scandal In...
In spite of the link title, the text was about this CDO deal. )
In my, non-specialist, language, I'd say that the investors in Australia were providing capital for an insurance company. If the company goes under, they lose their money. Of course, the "company" avoided typical insurance regulators.
This sentence is critical to me: "Nearly a quarter of the synthetic-CDO securities that started with investment-grade credit ratings from S&P have already been cut to junk, according to data from the rating firm."
I expect tha the investors were smply relying on S&P. In the absence of effective gov't regulation, the rating agencies had a lot of power.