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

Reducing the Value of the Firm

Big trades are executed through Wall Street market makers who, in many cases, buy and sell using their own inventories of stock. The market maker quotes a price based on its assessment of the market. The market maker who gets a buy or sell order from a speculator assumes the speculator has some insight about the firm; otherwise the speculator would do nothing. In general, knowledgeable traders contribute to market efficiency , assuring that share prices properly reflect firms' values. By inspiring confidence in the markets, this efficiency tends to hold prices up.

But in the authors' example, the speculator who is selling shares to the market maker through a short sale has no such insight. Therefore, his sale actually reduces the market's efficiency, enhancing the prospects for share prices to fall and make the short sale profitable.

In addition, the speculator can execute a series of short sales to drive down the share price. Seeing the falling price as a vote of no confidence, the firm will drop its spending plan, losing the benefit that plan would have brought and thus causing the stock price to fall further.

"On average, this is the wrong decision and will in itself reduce the value of the firm," the authors write. "This enables the speculator to cover his short position at a lower cost and make a profit. Due to the nature of this strategy, we refer to it as manipulation."

Of course, it's important that no one know what the speculator is up to, Goldstein says. "If everyone in the market knows that this hedge fund is trying to manipulate [the stock], then it will have no effect." It is essential, he adds, that the market's other players think the manipulator bases his decisions on insight even if he does not.

For the manipulation to work, the stock's price moves have to influence the firm's decision whether to go ahead with its spending plan. This is likely if three conditions are met: The value of the spending plan is not expected to be too high, there is a good deal of uncertainty about how the plan will turn out, and the firm expects to get useful feedback from the financial markets about the wisdom of its plan.

"Finally, we show that manipulation is profitable only via sell orders," Goldstein and Guembel write. "This is because the two sources of profit behind the manipulation strategy ... cannot generate profits with buy orders." The speculator who has no special insight into the firm will assume it is less valuable than the market price reflects, so he has an incentive to sell rather than buy, they note.

Similarly, a speculator operating without any special knowledge produces inefficiencies likely to cause the share price to fall later. To profit on falling prices, the speculator must use short sales; he will lose money if he buys the stock.

The key to market manipulation is the connection between share price and the firm's real value, Goldstein says. "Traditionally, people think about the financial markets as not affecting the firm. But that's not true."

For more on what happened with Bear Stearns, check out "Bear Stearns, Financial Investing and You" on TheStreet.com.

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