Crypto-Focused Silvergate Bank Got De Facto Backdoor FDIC Bailout via $4.3 Billion Federal Home Loan Bank Advance

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.

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18 comments

  1. chuck roast

    And the marijuana industry in California is denied standard banking services. Maybe we should put the DEA in charge of securities and investment fraud instead of the SEC and the OCC. At least we could be assured that all of the miscreants would eventually lounge at the Graybar Hotel rather than the 19th hole.

    Reply
  2. griffen

    Hoo boy, that is a doozy to consider. Hoping and I wish to suppose, that a senior risk executive actually did sign off on approving the advance to slivergate…eh, Silvergate. And in so doing, that risk executive becomes quite expendable in the event this goes south even more. Face it, once it hit that “small block of ice” even the HMS Titanic suddenly become quite sinkable.

    Reply
  3. notabanker

    Thanks for this really interesting post.

    Aside from the legitimacy of the deposits, did Silvergate suddenly invent a new way to instantaneously transfer crypto across exchanges that hedgies couldn’t figure out? Could there be some risk involved in spreads while those transactions were settling? Crypto price moves are certainly, um, volatile.

    Reply
  4. dftbs

    FHLB advances are secured by “by mortgages held in portfolio and other eligible types of collateral that the FHLB holds.” They are a rather expensive way to access funding, I believe that since 2020 the Discount Window has been both cheaper and is more accessible with respect to credit quality of collateral. I doubt that FHLB SF loaned Silvergate funds vs. Crypto assets.

    What is more likely is that Silvergate required liquidity and used its “liquid” assets to secure a loan for $4.3bln to meet its cash demands. These demands could most certainly been caused by “crypto contagion.” But I think it’s hard to characterize FHLB SF’s actions as a “bail out” of Silvergate. They are lending money at generous haircuts vs. what is considered good collateral, not crypto. They perform these advances to maintain stability in MBS markets, they have this role because they are the ones that create the securities.

    We can certainly question the wrong-way risk of an FHLB lending vs. securities they create in order to maintain market liquidity. We can question if banks like Silvergate paying onerous haircuts to FHLBs rather than liquidating positions and realizing loses puts into question the “highly liquid” characterization of those securities. But I do think its that the story sensationalizes the event and muddles its nature, and the role of FHLB SF, by adding “crypto” without any details to its place in this specific transaction.

    Reply
    1. Yves Smith Post author

      Sorry, if you have to go to a lender of the last resort for funding, which is what happened here, it is a bailout. Silvergate would have failed if not for the FHLB loan. I hate to get annoyed, but why you can’t see that is beyond me.

      The FHLB loan was over 1/3 of its peak total assets and over 3x its total equity.

      Silvergate never held any crypto. It held only dollars and euros (the latter is also really out of band for a small US bank).

      Silvergate clearly has large losses due to adverse interest rate movements. And it almost certainly will have 4Q operating losses and may have more deposits clawed back out of FTX/Alameda and potentially other crypto players going BK.

      Reply
      1. dftbs

        I do think that “bail out” implies an action that is beyond that provided for by established institutions/parameters. Certainly the actions following the GFC fit the bill, and the actions of Spring 2020 fit the bill. What Silvergate did appears to be within established parameters, it doesn’t indicate that they are a healthy operation, but it’s not an action outside of the norm for the FHLB to take.

        I apologize if that seems like a pedantic distinction; but I do think that coupled with the inclusion of “crypto” and all the connotations of that word, it makes the story seem more sensational than it is. Judging by some other replies to the story, there is a strong implication that the FHLB SF is taking on explicit crypto risk to “bailout” Silvergate.

        I believe there are a lot of questions with respect to risk management that FHLB advances raise. I don’t think this story raises them, but for lack of clarity it veers into a sensationalism.

        Reply
  5. Tommy S.

    Only would see this on NC. disgusting. That cash infusion is enough to house all homeless in California in dense urban REAL housing too, with mental health/social workers visiting……… BTW. But ‘we can’t afford that’…

    Reply
  6. Rip Van Winkle

    Excuse me while I revisit –

    Department Of Justice
    STATEMENT OF LANNY BREUER ASSISTANT ATTORNEY GENERAL CRIMINAL DIVISION
    BEFORE THE COMMITTEE ON JUDICIARY UNITED STATES SENATE
    ENTITLED “INVESTIGATING AND PROSECUTING FINANCIAL FRAUD AFTER THE FRAUD
    ENFORCEMENT AND RECOVERY ACT” PRESENTED SEPTEMBER 22,2010

    “The Department of Justice is busy investigating and prosecuting financial fraud in all its
    forms, including investment fraud schemes, mortgage-related fraud, securities fraud, insider
    trading, money laundering, and other crimes. Since the passage ofFERA, in May 2009, we have
    re-evaluated the manner in which we investigate financial fraud, the types of investigative
    techniques we employ, and the nature of our relationships with our law enforcement and
    regulatory partners. The Department’s participation in the Financial Fraud Enforcement Task
    Force has greatly facilitated this review, and has allowed for improved inter-agency cooperation
    with the SEC, the FBI, the U.S. Commodity Futures Trading Commission (CFTC), and other
    agencies. The Task Force has also improved our ability to ferret out financial crimes using
    aggressive investigative techniques.

    III. CRIMINAL PROSECUTIONS
    The primary work ofthe Department – and ofthe U.S Attorneys’ Offices and the Fraud
    Section ofthe Criminal Division in particular – is to ensure that we vigorously prosecute fraud
    and that those who commit financial crimes go to prison. Our investigations have been aimed at
    a wide range of fraudulent activity, including fraudulent investment schemes, securities fraud,
    bank fraud, mortgage fraud, procurement fraud, insider trading, and also disaster fraud.

    Through the increased resources afforded to the Department and our partnerships on the
    Financial Fraud Enforcement Task Force, we have made this fight a priority, and we will
    continue to do so. I can assure you that we will examine all allegations of fraud closely, follow
    the facts wherever they lead, and seek appropriate and tough punishments for individuals and
    corporations alike.”

    You can stop laughing now.

    Reply
  7. Arizona Slim

    I can only conclude that I’m in the wrong business. Sigh. I’m still looking for that big federal bailout.

    Reply
  8. skk

    When Marc Cohodes described in detail how FTX was a fraud in Nov, I started looking for their on-ramp/off-ramp guys, the guys who provided the conduits to send dollar money to FTX( and into crypto) and facilitated the reverse journey ( out of crypto and back into dollars in your own grubby hands, not inside FTX). I was certain those guys would be criminals too.
    I shorted quite a lot of SilverGate at 36/stock. Its now 12.

    Reply
  9. Valerie from Australia

    Thank you so much for this post. I wish more people would post this kind of information because many members of the public – if it was broken down and explained to them – would be furious. How many bank bailouts is the voting public expected to fund? I worked on both the Obama and Clinton campaigns and I can say with no reservations whatsoever, that I HATE both of these presidents and their financial administrations. I completely lay the fiasco of the current banking industry at their feet. The fact that “legitimate” banks are able to gamble on a Ponzi scheme like crypto and make loads of money for their shareholders and management while the going is good and then fall back on the taxpayer when things go South, disgusts me as a citizen and taxpayer. I only wish there was a way to claw back all those profits to pay for their carelessness and graft.

    Reply
    1. jinn

      Dear Valerie from Australia,

      Please allow me to inform you that banks are being blamed for the bad things Wall Street does and did.

      Its sounds like you don’t grasp that banks are the mechanism by which you are able to receive your income and pay your bills and safely save money. Wall Street is a Ponzi gambling outfit. Please do not confuse one with the other.

      Reply
  10. Maha

    If excessive energy consumption in a time of climate change is insufficient, then surely here is yet another reason to outlaw crypto. You can’t adequately regulate the cascade of outrageous behavior. Regulating will, like subprime and payday lending, simply legitimize the abuse.

    Reply
  11. GaryBless

    So, a while back I put $10 into the bitcoin ATM at my Stop & Shop. The ATM took my money and all I got was an email saying I now owned .0000321 bitcoin. The email said my .0000321 bitcoin was being held for my benefit at a secure, segregated bitcoin exchange called FTX.
    I wanted to buy some roast beef at the deli counter – I can only afford half a pound now – so I tried to get my $10 back. I couldn’t. Someone called SBF gave my BTC to Alameda. Is this SBF related to KFC?
    Why did my $10 end up at a place called Alameda Research run by some mousey Caroline lady doing drugs? Why did Alameda need to research my $10?
    Why did Alameda give my $10 to Binance?
    Why are the Bahamas involved? – Is that near Alameda CA?
    Are the Grateful Dead involved in this too?
    Maybe there will be a bailout….?
    I want my roast beef….

    Reply
  12. Karl

    RE: $4.3B Silvergate bailout

    How weird is banking in the US? Silvergate, a bank that was created for home finance gets caught in a run due to concerns over exposure to FTX and cryptocurrency operations. Now we get to see what’s under the hood of Federal Banking Laws:

    “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.

    Why was a Federal Home bank allowed to engage in cryptocurrency activities in the first place? The whole “prior lien” thing is an invitation to moral hazard at FDIC’s expense.

    Reply

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