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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Which mechanism best describes how the run on money market funds after the Lehman Brothers failure in September 2008 spread stress to the broader financial system?

After the Reserve Primary Fund broke the buck following Lehman's failure, investors redeemed heavily from prime money market funds. The funds hoarded liquidity and stopped buying commercial paper and bank debt, sharply reducing short-term funding for banks and corporations and spreading the crisis.

  1. AFunds that 'broke the buck' triggered redemptions, causing them to stop buying commercial paper and so cutting corporate short-term fundingCorrect
  2. BFunds were forced by regulation to buy distressed mortgage securities at par from banks
  3. CRedemptions were blocked by the Federal Reserve, which froze all fund assets
  4. DFunds raised their holdings of commercial paper to meet redemption demands

Explanation

The Reserve Primary Fund, holding Lehman paper, fell below USD 1 per share, prompting heavy redemptions across prime funds. Funds hoarded cash and cut purchases of commercial paper and bank debt, drying up short-term funding for firms. The other options reverse or invent the actual events.

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