The Death Spiral and Way out of Silvergate Bank
Translated by: GaryMa WuBlockchain
Recently, Silvergate made the following announcement: “In addition, the Company is evaluating the impact that these subsequent events have on its ability to continue as a going concern for the twelve months following the issuance of its financial statements.”
Here, “going concern” is an accounting term, which means bankruptcy risk. If a company has a bankruptcy risk within a year, it must be clearly stated in its annual report. This statement must not only be made by the company itself, but also in the auditor’s report. Obviously, this is fatal for a bank that relies on trust as its foundation. Perhaps there is a disagreement between the accounting and the company on this point, but if the accounting doesn’t sign, the company has no way out. Therefore, the company has exploded in this way.
What will happen? SI continues to sell bond securities and short-term loans, resulting in net loss. In the next two days, shark securities lawyers are likely to besiege the company, threatening to file a class action lawsuit for shareholders’ losses, just to get some settlement fees from the company.
But that’s not all, the real danger is a run on the bank. This is inevitable. SI has only over 1,000 customers, such as Coinbase, Gemini, Genesis, and Circle. Only $250,000 of their deposits in SI are protected by FDIC, and the remaining deposits may not be recoverable if SI faces bankruptcy risk.
Rational customers should withdraw their deposits as quickly as possible, which will lead to a death spiral for SI as a bank.
How did the death spiral occur? Why did it happen?
The cornerstone of a bank is reputation, where customers can withdraw their money at any time and maintain sufficient liquidity. It mainly relies on a large number of customers to disperse the risks in time and space, allowing customer groups to be as dispersed and lowly correlated as possible, and each customer is insured up to a maximum of $250,000 by FDIC. But these do not apply to SI. SI has only 1,000 customers, who are all in the same industry, with highly concentrated and correlated risks. If one customer suffers a loss, all customers may suffer as well. The FDIC insurance for individual users is almost non-existent. If there is no problem, it’s okay, but if there is, there will be a domino effect, just like what happened in 2008, when all banks were highly correlated with risks and the entire economy, leading to mutual runs on each other.
SI underestimated this correlation risk and did not prepare sufficient liquidity.
In Q4 2022 (October-November), as we all know, FTX was liquidated, causing many companies in the industry to be liquidated or bankrupt, many of which were SI customers, such as Gemini and Genesis, which needed to liquidate their assets to repay their debts. In the same period, various triangular debt equity stocks, customers’ withdrawals, and settlements led to a large amount of deposits being withdrawn.
How much did customers withdraw in Q4? Check the link.
Last year, the cryptocurrency price fell sharply, but the deposits in the first three quarters of the year remained between $13–14 billion, with little change, but the deposit balance fell to $6.3 billion at the end of the fourth quarter. In just one quarter, more than half of the deposits were withdrawn. This is a fatal blow to any bank.
This is the asset side of the SI.
These deposits were used to purchase various long-term and short-term bonds, commercial loans (including over 300 million in digital asset-backed loans, which pose little problem), and mortgages for interest income. Generally, public companies value their securities assets at their market prices at the time, but for banks, they hold bonds for a long time until maturity, so they only need to record the cost price of the bonds on the asset side. However, when banks plan to sell these assets, they need to value them at market prices. This is why SI recorded over $800 million in securities losses in Q4. In addition, nearly 200 million were software assets purchased from Facebook’s Libra, which I analyzed in a post a year ago and predicted would inevitably fail. The sooner you give up, the sooner it ends, to avoid incurring further development costs.
The liability side (i.e., customer deposits) is being withdrawn, and the asset side (i.e., the held bonds) is continually decreasing in value due to rising interest rates, which puts SI in a double squeeze. SI can only maintain liquidity by borrowing short-term loans from other banks or financial institutions, but these short-term loans have liquidity and leverage requirements for banks. As customers withdraw more money and assets continue to decline in value, the net worth belonging to shareholders will decrease to a certain extent, triggering the bottom line of the leverage ratio and resulting in default on short-term debt. SI will be forced to repay more short-term debts and sell more bond assets, causing further deterioration of financial conditions, triggering banking regulations (unable to lend, forced to shrink) and accounting bankruptcy liquidation risks. This information disclosure is a credit crisis for SI, which only has 1,000 customers, and will inevitably lead to further customer withdrawals (run), fire sales, winding down, and larger losses. SI is currently facing a death spiral.
The only way out for SI now, which they must be working on, is to find a larger bank to acquire them. This is a very likely possibility and may be announced within the next one or two days. Otherwise, the consequences will be unimaginable, and SI will face the same predicament as Bear Sterns and Merrill Lynch did in 2008. Since SEN itself has value, selling the company would be the best way to maximize shareholder value. However, there are several challenges:
1. The larger bank would need to use its own brand to take over the business (SI Bank would no longer exist), but due to scandals and bankruptcies in the crypto industry, this could harm the reputation of the larger bank.
2. Regulation of the crypto industry will only become stricter, which will increase future regulatory costs. This is already reflected in the increase in staff numbers in Q4 and SI’s forced abandonment of small deposit customers. In the future, this part of the business may increase the regulatory costs of the larger bank and may not be worthwhile.
3. In addition to common stockholders, there are also $200 million worth of preferred stockholders. This will need to be negotiated during the merger, based on the rights and interests written in the preferred stock equity agreement. This will increase the difficulty of the merger.
4. If there are securities lawyers involved in the next few days, it will increase the risk of class action lawsuits, which the larger bank will naturally assume when acquiring SI. This will make it even more difficult.
Overall, the likelihood of being acquired is high, and SI is surely working to find a buyer. However, a high stock price will make it harder to be acquired, especially considering the above risk factors.
The net asset value per share at the end of last year was $12.93. If the bond sell-off continues to devalue $200 million, the net asset value per share is $6.6 based on 31.66 million shares. The current stock price is $6.85, and the valuation seems too high, which may deter potential acquirers from making an offer lower than the market price, as they could face lawsuits from retail shareholders in the future.
The stock price is expected to continue to decline over the next few days until there is news of an acquisition. The acquisition price is likely to be $5–6 per share.
If there is no acquisition, the death spiral will continue, and there is a possibility that the SI stock price will drop to zero.