'Bear Raids': How and When They Work, and Who Benefits

When Bear Stearns BSC collapsed in March, some insiders argued it was wrong to blame the firm's risky bets on mortgaged-backed securities . They had another culprit: malevolent traders working together in the upside-down world of short sales -- making money by knocking down Bear's stock.

No one openly admits to conducting a "bear raid," since deliberately manipulating stock prices is illegal. But Wall Street has long believed bear raids can and do take place. There has, however, been little academic research to explain the forces at work. Now two finance experts have shed some light on the process. "We basically describe a theory of how bear raid manipulation works," says Wharton finance professor Itay Goldstein. He and Alexander Guembel of the Saïd Business School and Lincoln College at the University of Oxford describe the procedure in their paper titled, "Manipulation and the Allocational Role of Prices."

Their key finding illuminates the interplay between a firm's real economic value and its stock price, showing how traders who deliberately drive the share price down can undermine the firm's health, causing the share price to fall further in a vicious cycle.

"What we show here is that by selling [the stock], you have a real effect on the firm," Goldstein notes. "The connection with real value is the new thing.... That is the crucial element."

Goldstein and Guembel find that the process only works when the intent is to damage the firm; traders do not have the same power to create a feedback loop that drives the share price up.

The key to the process is the short sale, when a trader borrows shares from a broker , sells them and hopes to repay the loan with shares bought later for less. The short seller profits only if the stock price falls -- selling high and then buying low. If the price goes up, he has to buy replacement shares for more than he made on the ones he sold.