Question about credit default swaps -- can damage be limited because of "physical settlement"?

One of the criticisms of the credit default swap market is that the people and companies that bought "insurance" on debt (often called the "reference security") didn't have to own the debt. That meant that the widespread selling of cds was like people buying fire insurance on homes they did not own.

It also meant that sellers of cds, like AIG, could get into trouble by selling many times the value of an entire outstanding security. For example, if Bear Stearns issued $100 million of, say, Series A Mortgaged Backed securities, if cds were like insurance and you had to own the property to insure it, the maximum exposure of a cds seller like AIG on that security would be $100 million; but if anyone could buy cds, then it was like gambing and if 50 times as many people bought cds on Bear Series A MBS, then AIG's exposure would be 50 x $100 million = $5 billion

But don't many cds require "physical settlemnt"? In physical settlement, the owner of a cds must present the actual insured bond to get paid. In the example above, no matter how many cds AIG had sold on that series, the only cds holders who could cash them in would be those who had, or could get hold of, an actual physical Bear Stearns MBS certificate (or a depository equivalent). All other holders of cds would be out of luck -- appropriately so.

I vaguely remember this to be true. During the Lehman liquidation, iirc, cds holders tried to cash in their cds on defaulted Lehman bonds, but suddenly there was shortage of defaulted bonds because so many cds holders were trying to buy them. In fact, it caused a weird rally in defaulted Lehman bonds.

So if physical settlement is required, doesn't that basically eliminate the entire problem of cds liability being bigger than the amount of the underlying reference securities?

eventually the short sellers have to cover themselves by buying the stock and that purchase activity establishes a floor on the market.

To quote Satyajit Das,

"In practice, there are actually two settlements. The ‘real’ settlement where genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds and were hedging). Then there is the parallel universe where the dealers and large hedge funds settled via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).

For example in the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300-400 billion. Some banks and investors that had sold protection on Lehmans did not participate in the auction. They chose to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that are now worth $30 million.

One reason that there were no failures in settlement of the CDS contracts is sellers of protection such as banks and some insurers were propped up by governments concerned about systemic failure of the financial system. Other sellers of protection had to bear losses reducing the capital available to meet future claims. Whether the sellers are in a position to meet potential losses if default rates rise as expected remains unknown.” "