Sure, I get to sit at home on my ass all day but there's also the feeling of uselessness and the accompanying frustration.
Mate, I know exactly what you mean here. I've been in a similar situation, and while it IS fun for a while to come to work, kick back, read Slashdot, make phone calls, etc., and pick up a fat paycheque at the end of the week - the fun doesn't last, and is ultimately destructive.
From your mention of "uselessness" and "frustration", I suspect you're already well past the fun stage. 9-to-5 is a long time when you have to keep yourself occupied for lack of work. And the dangerous thing is, the longer it goes on, the more likely you are to slide into a sort of decay where you just don't have the necessary enthusiasm to pull yourself out. It is, in a very real sense of the word, depressing to have a job with nothing to do.
I could start looking for a new job then quit but I get the feeling that the market in my city is more competitive right now so finding a challenging job I would like isn't necessarily a sure thing.
Remember, you're in the enviable situation where you can look for a new job without NEEDING one. Hunt around. Be picky. If you don't find a good job quickly, that's OK, you just sit at your current job and KEEP LOOKING! Trust me, job-hunting is SO much more bearable when you're sitting on your ass at work than when you're at home, spending your savings and running up credit card debts. I've done both. :-)
On the other hand, I could stay and use the free time to work on my own mini projects.
A worthy idea, and one which I pursued. I taught myself Perl and Python while in my bone-idle job situation. But as you say, it can be hard to focus on something like that without a good reason. If you feel like you've exhausted the possibilities of using your job as a base for self-learning, again, time to go, before you get (more) depressed.
I could also stay and hope that my company lets me go, giving me the minimum two months compensation required by law in my country.
I'd advise against it. It might happen, it might not, and even if it does, sure, you get the cash, but then you're jobhunting with the "I NEED a job" attitude, rather than the more relaxed one you could take now. Next thing you know you've accepted a job that's only OK, not great. Nah, I say, start looking now.
Hope that helps!