'ABSTRACT’ “We examine the desirability of granting “safe harbor” provisions to the sale and repurchase (repo) markets, i.e., granting repo contracts exemption from automatic stay in bankruptcy. Such exemption can enable financial intermediaries to raise greater liquidity and operate at higher leverage in normal times. This liquidity creation occurs, however, at the cost of ex-post inefficiency when there are adverse aggregate shocks to the fundamental quality of collateral underlying the contracts. When exempt from bankruptcy, creditors of highly leveraged financial intermediaries respond to such shocks by engaging in collateral liquidations. Financial arbitrage by less leveraged financial intermediaries equilibrates returns from acquiring financial assets at fire sale prices and those from real-sector lending, inducing a rise in lending rates, a deterioration in endogenous asset quality, and in the extremis, a credit crunch for the real sector. Given this inefficiency, an automatic stay on repo contracts in bankruptcy can be not only ex-post optimal, but also ex-ante optimal, especially for illiquid collateral with high exposure to aggregate risk.”