Yes the question on who owns the CDS' may be another scandal in itself.

Never-the-less, It is easily within the power of the government to declare CDS over value as illegal, If they want to be especially fair they could  default the CDS value but return the premium in the same way as an insurance company does if there is a dispute over an insurance discosure. Say you insure your car against theft but dont disclose that although your neighbourhood is safe your girlfriend lives in "the hood". The insurance company might disqualify your claim but have to pay back the premium. Or even more on point you insure your car with two companies. In that case currently either the two companies share the payout or one company defaults and returns your premium. If you try to claim from both in the full amount you end up in jail for fraud. That is what whould happen to crazy CDS over purchasers

Clearly this would cause a vast drop in apparent paper "wealth" for some. The question is are any financial firms assets entirely in CDS paper? If so I would say they are so clearly insane that they and all their investors deserve what they get.

These "weapons of mass financial destruction" representing a Quadrillion dollars in the world markets CAN not be real in a world economy of only 62 trillion. Clearly a quadrillion dollars was never PAID for these intruments the notional value depends on assessing all the "bets" as wins.

If the entire market is delcared illegal no actual money can come out of the real economy since no money from the real economy exists in the notional quadrillion value of the derivatives. A whole lot of people will be pissed off of course but the credit market would not dry up because the banks would not be chasing credit each day to voce margin calls on the derivatives and there would actually be again a vast amount of cash sloshing around looking for a home.

Currently because of the fear that one bank or another will be swallowed by margin calls on CDS cash is flooding Tbills at near and sometimes below zero return. Get rid of the derivative bomb by declaring multiple value CDS on single entities illegal and the problem is over. You have to completely re structure the world economy of course but

details details!