I can see unscrupulous real estate people thinking it. They don't care about what happens when the balloon goes up - they just want the sale now. It was a hot market and they wanted in.
I can see the buyers thinking it. "It's a great deal! The future will take care of itself!"
The banks who financed it... okay, wait. You're not even making that much in interest for the first 5-7 years. You have no reason to believe these buyers can make the payments after that. But maybe it's the same sort of wishful thinking as the buyers. "But we want more big fat mortgages! Surely not everyone will default!"
The insurance firms: WTF were you thinking? Out of all of these groups, you're the ones whose job it allegedly is to assess risk and put a price tag on it. Out of everybody, you're the ones who can least afford it if that risk assessment is wrong, because you're the bag man. You know how your home insurance brethren have stopped insuring homes located in certain flood areas? Yeah, because it's a bad risk.
You make your money by playing the odds. You therefore ought to study them very, very carefully.
How did this seem like a good idea?