Kate Berry in American Banker has done some important sleuthing in her new American Banker story, Silvergate Bank loaded up on $4.3 billion in Home Loan bank advances. Berry gets to the bottom line in her story, but the American Banker exposition style resulted in the really bad stuff that would be obvious only to banking industry regulators and insiders coming close to the end.
The 50,000 foot version is that because Silvergate focused on handling fiat-currency transactions of crypto traders…like FTX, Alameda Research, Gemini, and Coinbase. when it was hit by a bank run, it went to the Federal Home Loan Bank system for a $4.3 billion bailout. Silvergate could do that because in its old boring days as a traditional bank, it was in the mortgage business and hence had access to the Federal Home Loan Bank facilities, and maintained them despite its transformation into an institution with a very different risk profile.
As Berry explained, the Federal Home Loan Bank of San Francisco rescue was tantamount to a FDIC bailout. From her story:
Another quirk of the Home Loan Bank System is that, if a member bank fails, the Home Loan bank can assert statutory lien priority on other assets — essentially putting the Home Loan bank ahead of all creditors. Because of this protection, no Home Loan bank has ever lost a penny on an advance. Some critics suggest that the priority position of the Home Loan banks, which stands ahead of the FDIC’s deposit insurance fund, allows the bank system to ignore the risk of failure when pricing advances. Some critics suggest the Home Loan Bank System creates a moral hazard because the FDIC cannot charge fair premiums to offset the unpriced risk of failure, shifting the downside risk to the FDIC.
“The Home Loan banks love to say that they’ve never lost a nickel and that’s because they have a prior lien ahead of the FDIC,” Petrou said. “The $4.3 billion is clearly at risk and it leaves the FDIC holding the bag.”…
The Home Loan Bank System, Petrou said, is forcing the FDIC “to rescue the irredeemable.”
Already experts are prognosticating what will happen in a worst-case scenario for Silvergate and for regulators. The Home Loan bank stands ahead of other creditors and the FDIC.
“If the FDIC walked in and had to close the bank, the Home Loan bank takes the first $4.3 billion of whatever the bank has that’s worth taking, leaving the rest to the FDIC,” Petrou said.
This incident may explain the sudden issuance at the start of the year of a strictly-worded joint letter by the three national banking regulators, the Fed, the FDIC, and the Office of the Controller of the Currency. They warned that dalliance with crypto and being a bank didn’t fit well together very well. From their missive:
- The agencies are continuing to assess whether or how current and proposed crypto-asset-related activities by banking organizations can be conducted in a manner that adequately addresses safety and soundness, consumer protection, legal permissibility, and compliance with applicable laws and regulations, including anti-money laundering and illicit finance statutes and rules.
- Issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.
- Business models that are concentrated in crypto-asset-related activities or have concentrated exposures to the crypto-asset sector raise significant safety and soundness concerns.
Silvergate is now under serious regulatory scrutiny, which is likely to include whether it participated in money laundering. This is not far-fetched; the Department of Justice’s seizure of SBF’s Robinhood holdings is in part based on money-laundering allegations.
But aside from that, Silvergate went whole-hog for slip-shod management, just like its crypto customers. It takes some doing have screwed up so badly that you would have gone bust ex an emergency infusion, when your business consisted solely of taking deposits and investing in liquid securities….well and then it turns out derivatives too. From Bloomberg on January 5:
Silvergate Capital Corp. shares plunged after the bank said the crypto industry’s meltdown triggered a run on deposits, prompting the company to sell assets at a steep loss and fire 40% of its staff.
Customers withdrew about $8.1 billion of digital-asset deposits from the bank during the fourth quarter, which forced it to sell securities and related derivatives at a loss of $718 million, according to a statement Thursday.
Silvergate was the finance analogue of a guy going through a midlife crisis who divorces his wife, buys a fast car, starts wearing topaz rings and dating women who weren’t born with their current physical endowments. It was a tiny La Jolla mortgage lender whose CEO became a Bitcoin enthusiast in 2013 and noticed that even sorta-respectable crypto companies had trouble getting bank accounts to do fiat-world things like pay rent.
Silvergate quickly built up a traditional, plain vanilla banking services business to crypto companies and exited its boring mortgage operations. But it had crazy concentration risk, with 90% its customers being major crypto players and one might suspect, the big names accounting for a large percentage of total deposits and transaction volumes. Still, that was not the craziest thing Silvergate did. This was, per a Wall Street Journal podcast:
David Benoit: So as the money sort of flowed in, Silvergate realized a second issue for the crypto industry, which was it was hard for someone who was investing in crypto to move money between various exchanges.
Ryan Knutzen: Before Silvergate, big investors, like hedge funds and pension funds, had to go through a lot of steps to move cryptocurrency from one crypto exchange to another. It was complicated and slow. So Silvergate stepped in and created the Silvergate Exchange Network. It allowed customers to move money between exchanges instantaneously. Silvergate launched its Exchange Network in 2017, and that’s when its business really started taking off.
David Benoit: It became a place where if you wanted to get money into the exchanges, this was a very easy way to do it and their growth expanded pretty quickly and their deposits went from something like 5 billion just a couple years ago to 14 billion last year. So almost all of the big exchanges had accounts at Silvergate and then new investors who wanted to put money into the exchanges started going to Silvergate if only to make it easy to move money back and forth.
Help me. That means Silvergate put itself in the middle of big money movements in and out….which became pretty much all out as the crypto crisis hit. Silvergate’s January 5 news statement indicates:
During the quarter, Silvergate sold available for sale securities, as well as certain securities that were previously identified as held to maturity.
That’s an admission Silvergate screwed up and misjudged its liquidity needs.
And to make matters worse, according to the American Banker story, Silvergate didn’t even stress test their portfolio for interest rates moves! Or if they did, they did it incompetently and/or didn’t act on it. From the article:
“This is where risk management is ludicrously bad,” [Todd H.] Baker [senior fellow at the Richman Center for Business, Law and Public Policy at Columbia Business School and Columbia Law School]continued. “They weren’t thinking about the fact that all these securities — which, when they bought them, interest rates were low — that when rates go up, the value of securities drops. At some point they realized that when they sold the securities, they’d take a huge loss.”
That’s actually a charitable interpretation. Silvergate may have knowingly taken on excessive interest rate risk because they knew they could use the Federal Home Loan Bank as a backstop.
But back for a second to the Wall Street Journal business overview. Did you catch that word, “instantaneously”? Silvergate assumed that because money was deposited with them, they could safety transfer it between accounts, within the bank. Not such a good assumption when dealing with dodgy customers.
First, as we can see from Silvergate’s news release, the $718 million it lost from dumping securities does not represent all of its potential red ink. Investors and customers are still in the dark, since Silvergate isn’t publishing its quarterly financials until January 17. Consider:
As of December 31, 2022, approximately $150 million of Silvergate’s deposits were from customers that have filed for bankruptcy.
If those customers are FTX and Alameda, or those deposits are mostly from them, Silvergate can kiss that goodbye too.
Second, recall that Silvergate is axing 40% of its staff, which strongly suggests its 4th quarter results will also show a big operating loss.
And as regulators are starting to go full proctological on FTX, they may also find money laundering abuses and could freeze or even seize assets related to that. And Silvergate should also be hit with some fines.
Now Silvergate did have about $1.4 billion in equity as of the end of the third quarter. But IMHO they have to set up a 100% loss reserve against that $150 million of deposits from customers in bankruptcy. So the hit to equity is likely to be more like $900 million and could be higher. And do they even have a viable business going forward?
One silver lining in this mess (pun intended) is that it coincides with a Federal Housing Finance Agency review of the Federal Home Loan Banks. Elizabeth Warren, who learned a thing or two about housing and mortgages back in her time as head of the Congressional Oversight Panel for the TARP, has already taken an interest in crypto implosions. It’s not hard to image that she’ll have company in asking why a quasi-government mortgage lender was rescuing a bank dedicated to the crypto industry.