How the Shiny Ball Bounced from Crypto, to Tech, to the Banks who Loved Them

Last week, there was an FDIC insured Certificate of Deposit offered yielding 13.8% and maturing in just 2 short weeks, while other banks were paying substantially lower for the same term. If it sounds too good to be true, it likely is. Investors get paid to take risk, so it was no surprise when the next morning that issuer, Silvergate Bank, announced a voluntary wind-down of operations and liquidation of the firm. Silicon Valley Bank, which lends primarily to start-up technology companies, was taken over by the FDIC yesterday. How can a bank such as Silicon Valley with over $200 billion in deposits fail?

When the economy is a bit too hot, the Federal Reserve increases short-term interest rates to gradually cool things off. Just a year ago, short term rates hovered above zero. During March of last year, the Federal Reserve initiated a series of increases to the Fed Funds Rate, which is the rate banks charge each other for overnight lending to meet reserve requirements. Today, after a series of the most dramatic increases ever seen, that rate is 4.5%-4.75%. Rising interest rates favor banks in that they can charge more on loans they issue, however as rates rise, the value of the fixed income investments in their portfolios falls, which can pressure their balance sheets and hamper their ability to meet customer withdrawals. A rising interest rate environment will separate strong banks from the weak. As rising rates slow the economy, other sectors of the market are also differentiated and previously high-flying investments fall out of bed. These two banks show how intertwined risks can become.

The crumbling of FTX last year catalyzed the beginning of the fall of cryptocurrency, which was the canary in the coal mine for frothy, speculative investments. Silvergate Bank, based in La Jolla, California, was the posterchild of froth as they had very few retail customer deposits, and held deposits of speculative venture capital funded start-ups, unproven technology companies, and, of course, cryptocurrency. It also operated an exchange to convert cryptocurrency into dollars, the Silvergate Exchange Network, which was shut down a week ago. No surprise that the largest customers on their exchange included FTX and Alameda Research. Silvergate Bank was founded in 1988 with a focus on real estate lending, but over time got lured into the shiny-ball markets of cryptocurrency and hot new technology companies. Rising interest rates and tumbling crypto prices ultimately led to a classic run on the bank and forced Silvergate to sell bonds at losses to meet demands. The weakness of speculative investments in crypto and unprofitable nascent technology companies were intertwined for Silvergate, as their business was almost solely concentrated in these spaces, and led to their failure.

The Silvergate and Silicon Valley failures come as no surprise as their business models were not properly diversified and were heavily concentrated in speculative areas. The chart below shows that Silicon Valley Bank (SIVB) was an extreme outlier – the strongest banks are in the upper left corner, and the banks with the riskiest profiles are in the lower right corner. Last December, I sold shares of Bank of America (BAC) from the Pawleys Dividend Fund, and added to shares of JP Morgan (JPM), as JPM has a lower risk-profile than BAC. Financial stability becomes increasingly important as the economy slows. This holds true for all sectors of the market, which is why I avoid frothy investments and focus on selecting stocks of companies with little or no debt, solid earnings growth, and rock-solid cash-flow. The historical performance numbers speak for themselves.

Sources: JP Morgan Asset Management, Silvergate Bank and SVB Financial (parent company of Silicon Valley Bank) Quarterly Filings.

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