Aaron,
You have a pretty good understanding of HDCP already, and your assumptions are correct. However your other designer friends are also correct.

It is possible to make a DA or matrix switch that will allow for multiple sources and multiple displays, all supporting HDCP. In order to do that, each input DVI/HDMI receiver chip must understand and decrypt HDCP. Then the distribution and routing can take place inside the switch unencrypted. Final stage at the output is the DVI/HDMI transmitter chip that supports HDCP, and will encrypt the data on it's way out. So really you have more than one seperate HDCP session going on, the ones between the source devices and the switch, and others between the switch and the displays.

If you need to switch multiple sources into one display, you can sort of cheat the system by not decrypting the data, and letting the source talk directly to the display. In that case the source and display have no idea there is a 'man in the middle', and it is only a single HDCP conversation. That is the method used by most DVI switches on the market that support HDCP.

I beleive Gefen has obtained the proper license from HDCP, so they can now decrypt that video, and do things like a DA that supports HDCP on all outputs.