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

Which mechanism best explains why the run on money market funds after the Reserve Primary Fund 'broke the buck' in September 2008 spread to the wider financial system?

Redemptions from prime money market funds forced them to hoard cash and stop buying commercial paper and other short-term debt. This removed a major source of short-term funding for banks and corporations, spreading the run beyond the funds themselves until a government guarantee was introduced.

  1. AInvestor redemptions forced funds to stop buying commercial paper, drying up short-term funding for financial and nonfinancial firmsCorrect
  2. BRegulators required all funds to convert to equity funds, forcing sales of shares
  3. CFunds were compelled to buy large amounts of Treasury bonds, raising yields
  4. DInsured bank deposits were withdrawn from banks and placed in prime funds

Explanation

After the fund's net asset value fell below USD 1 because of Lehman paper, investors redeemed from prime funds. Funds hoarded cash and cut purchases of commercial paper and other short-term debt, shutting a key funding source. The government responded with a guarantee program for money funds.

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