4/16/2008: 'Bear Raid' Stock Manipulation: How and When It Works, and Who Benefits

Excerpts from 'Bear Raid' Stock Manipulation: How and When It Works, and Who Benefits

When Bear Stearns 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."
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[I]f the falling share price caused by a bear raid does real economic damage to the firm, other investors are likely to dump the stock as well, causing a vicious cycle of falling share prices and economic damage that would make the bear raid more profitable.

Sabaziotatos says:

This is precisely the kind of manipulation that I discussed in Sabaziotatos calls on SEC to investigate "gaming" of ABX. "Wash trades" at depressed price levels in the illiquid OTC market tracked by the ABX index most definitely could damage the "real value" of a financial services firm: fair value accounting would require the firm to mark its assets to market against the index; the lower mark would result in writedowns of asset values on the balance sheet; the writedowns would not only reduce capital ratios, but also cause a loss of confidence, which would feed back into the ABX. As the good professors point out, this rapid, self-reinforcing, pro-cyclical loss of confidence can be deadly.