The bright, liquidity-driven prospects for the stock market, versus the hard landing for the US economy, have been a puzzle all year. Prolonged weakness in the economy without some stock market weakness would be odd. Yet the implication of a hard landing, lower interest rates, has even boosted stock prices, given the predominance of debt-driven private buy-outs in setting prices.

The Bear Stearns hedge fund fiasco removes the paradox. Banks’ capital is about to be slashed, and with it excess liquidity in the global system. Look at mortgage-backed collateralised debt obligations -– pools of debt assets, in which investors take stakes with different levels of risk. Suppose the CDOs held by banks were valued at “market” rather than “model” levels (a fancy new euphemism for illusionary historic book values). Their capital would turn out to be lower. Preservation of capital ratios against loans would require fewer loans: liquidity would have imploded.

Bear Stearns has made a $3.2bn secured loan to one of its hedge funds. Yet this is the better of the two that are threatened with collapse. Investors in the more highly indebted one face bleaker prospects. Yet in neither of these funds is one likely to find much of the low-quality, “toxic-waste” CDO paper.

These funds mostly hold the higher-rated, single-A (and better) paper that is protected from the first impact of any defaults in the underlying mortgages. By what? By the lower-rated toxic waste that takes the first few percentage points of default on any of the underlying mortgages: this stuff is optimistically rated at such levels as BBB-minus. Only defaults above the rate that wipes out the low-rated paper affect the higher-rated paper. Hedge funds generally deal in the upper-rated, single-A and better, paper.

But even with this support the attempted liquidation of $800m of mortgage-backed collateral seems to have hit a rather large rock: after getting bids of a mere 85-90 per cent of face value for about a quarter of the securities, the auction was called off: better to let the Bear flounder than reveal just what a low value the Street puts on even the A-rated paper.

A bunch of hedge funds may have problems, but that is the tip of the iceberg for “Titanic” Wall Street. Who holds the toxic tranches? Answer: the originating banks and syndicating investment banks for the most part.

As these lower-rated tranches retain the bulk of the credit risk in the mortgages, their retention by such banks means the much-trumpeted shifting of credit risk off balance sheets was less than met the eye. If the higher-rate stuff is worth 85-90 per cent of face value at best, what is the value of the $750bn of mortgage-backed securities said to be held in US commercial banks’ balance sheets?

The toxic tranches have been valued in recent days at prices as low as 60 per cent of face value.

If a fair proportion of $750bn is wiped out by mark-to-market – or the simple incidence of losses – that will be a fair proportion too of the commercial banks’ $875bn of capital. And how good are the balance sheets of the major investment banks?

Liquidity is a complex thing. It can mean simply the ability to place a large line of stock at the broadcast market price. This creates debt capacity for the investor, of course, as leverage becomes safer: the result is growth in loans and deposits, which is how liquidity is often measured.

With this mortgage-backed crisis we could simultaneously see market-price liquidity implode just as banks are forced to shrink their books by capital losses. It was always likely that the chief source of problems (as in any downswing) would be the chief area of excess in the previous boom – in this case the mortgage market and mortgage-backed securities.

Defaults are at their highest in the 37 years records have been kept; adjustable interest rates and withdrawal of “teaser” start-up rates on recent mortgages are still largely to come. It could be a long, hot summer. Any major non-Fed rescue operation or cover-up adds to the risk: rumours without solid information make fertile ground for panic.

Charles Dumas is chief economist at Lombard Street Research