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February 16, 2022 | When Facebook (FB) CEO Mark Zuckerberg sold his infant coin business Diem to Silvergate Capital Corp (SI), he accepted a lesson that Walmart (WMT), Alphabet (GOOG) and Apple (AAPL) have all learned over the years: banks have a federal monopoly on creating deposits and making payments. If you want to take deposits or have a hard IP address on the national payments system, namely a master account at a Federal Reserve Bank, then you got to be a bank. That is, a federally insured depository institution. Just ask Sarah Bloom Raskin. But who is Silvergate and why is this small bank from La Jolla, CA, buying FB’s stable coin business Diem?
The simple answer to that question is that SI’s management team are smart and are taking advantage of the narrative in Washington, which is that stable coins will be a bank only product. We see SI as an audacious gamble on the interface between all crypto and fiat cash money, not simply stable coin tokens. At the same time, however, SI is not a very impressive model of a bank and has risks that most community banks do not face.
This $16 billion asset bank, which had just $2 billion in assets at the start of 2019, trades at “only” 2.4x book today. It was trading just shy of 12x book in March of 2021, at the peak of the COVID market pump by the Federal Reserve. And why not? In the world of financials, Silvergate may be among the biggest meme stocks yet in the era of quantitative easing or QE.
SI is not your typical bank over $10 billion in total assets. In fact, SI and its state-chartered bank unit, Silvergate Bank, grew so fast over the past year that the bank is not yet officially a member of Peer Group 1. SI is going to be dropping form Y-9C with the Fed shortly and providing other detailed reporting not available today.
The growth in the bank’s assets has been matched by an equally torrid growth on the public market value of SI, as shown in the chart below. Very briefly, this crypto-focused bank was among the most highly valued banks in the US. But over the past year, SI has lost two thirds of its market value.
Source: Yahoo Finance
Founded in August 1988 as Silvergate Thrift & Loan Company, today the bank has $16 billion in total assets funded with $14 billion in certificates of deposit, most of which mature in one year or less. At December 31, 2021, Silvergate Bank had $1.7 billion in loans, $7 billion in Treasury securities, MBS and munis, and other $5 billion in deposits with other banks. The muni market has backed up about 60bp in yield since the start of 2022, of note.
Because of the atypical asset structure of the bank, profitability is poor. Silvergate Bank ranked in the bottom decile of Peer Group 2 at the end of 2021, with net-income to average assets of just 72bp vs an average of 1.29% for Peer Group 2, which includes 115 banks from $10 billion to $100 billion in assets. The relatively weak fundamentals of SI and its subsidiary bank, however, have not prevented the stock from going “to the moon,” to borrow the language of Reddit, as shown in the chart below.
Notice that meme stocks such as SI and Tesla (TSLA) exploded when the FOMC began to make massive purchases of securities via QE in Q1 of 2020. In relative terms, the 90% up move in the S&P 500 over the past year barely moves the needle compared to SI (800%) and TSLA (+1,600%). And both of these MEME stocks have been correlated to moves in bitcoin and the VIX over the same period.
SI has positioned itself as an enabler for crypto transactions, on the one hand, and a lender against crypto assets, providing greater “capital efficiency” (aka “leverage”) for institutional investors. In January 2020, SI began offering a new lending product called SEN Leverage, which allows Silvergate customers to obtain U.S. dollar loans collateralized by bitcoin held at select digital currency exchanges and other custodians.
For the three and nine months ended September 30, 2021, there were $162.0 billion and $568.1 billion, respectively, of U.S. dollar transfers that occurred on the SEN, compared to $36.7 billion and $76.5 billion, respectively, during the three and nine months ended September 30, 2020. The outstanding balance of SEN Leverage loans was $254.5 million and $77.2 million at September 30, 2021 and December 31, 2020, respectively. Think of it as warehouse lines collateralized with nothing and funded by FDIC-insured deposits.
Most of the jumbo CD deposits we referenced earlier bear zero interest, providing what SI describes “mid-single digit spreads” in an investor presentation. The Silvergate exchange network or “SEN” allows 24/7 real time transfers of dollars and now euros, into and out of crypto assets. These flows totaled $35 million of transaction revenue, but also create risk for the bank, including facing a number of nonbank counterparties that are lightly capitalized and even less subject to prudential regulation. Robust AML and KYC compliance are perhaps the biggest challenges for this bank because of the essentially offshore nature of crypto trading.
Source: SI Investor Presentation (February 2022)
A growing area of business for the bank is lines of credit and letters of credit for crypto trading, which SI books as off-balance sheet liabilities. While the amounts are small relative to the bank’s capital, the amounts are growing steadily. Total off-balance sheet items were $119 million at the end of 2021 vs $57 million at December 31, 2020. These items were assigned 100% risk weights by regulators and equaled roughly 10% of Tier 1 capital at year-end 2021.
Shareholders’ equity increased $777.8 million to $1.1 billion at September 30, 2021, compared to $294.3 million at December 31, 2020. The increase in shareholders’ equity was primarily due to two common equity offerings. The bank will need to continue to grow capital to support a larger asset and deposit base, but so far core profitability is not providing sufficient support for capital growth.
Our bottom line on SI and Silvergate Bank is that the bank part of the business is mediocre and unlikely to deserve a valuation multiple much above its asset peers, which means a book value multiple of equity closer to 1 than to 12. The operating efficiency of the bank at 43% is good, but expenses are rising faster than non-interest income, which seems to be the point of the business model. Income from assets is modest and does not leave the bank’s management much room for error in terms of either interest rates or credit.
If you believe that crypto is a long-term investment asset, then SI seems to have stolen the march on some if its larger competition. The volumes moving through the SEN network are impressive, but it is less than clear how the bank benefits from these flows besides making loans against crypto assets as “collateral.” The funding structure of the bank is unusual and, in extremis, volatile since a large portion of the deposits reprice within one year. We also wonder if higher levels of market volatility are not going to hurt the already modest returns that that the bank earns on assets. As interest rates rise, the attractiveness of the bank’s zero interest rate deposits may decline.
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