This paper analyses the European financial crises through the lens of the sovereign bonds liquidity. Using novel data it shows that government securities are used to a large extent as collateral in the European repo market, which has becoming a primary source of liquidity for the banking system. It also documents that haircuts of Irish and Portuguese government bonds largely fluctuated during the crisis amplifying the movements in the yields of these securities and tightening the link between sovereign and banking crises. We represent the rise in haircuts as a liquidity shock in a DSGE model with financial frictions to study its impact on the price of bonds and on the business cycle. The model suggests that a liquidity shock results in a flight-to-liquidity and a reduction of the economic activity through a fall in investments and that an unconventional policy may reduce the contractionary effect on the economy by issuing a liquid short-term bond.