Too Important to Fail? My Misguided Trust in a Doomed Crypto Bank’s Resilience

It’s never fun to be reminded of terrible investments.

The other day, I was going through a rarely revisited desk drawer. There was this digital video camera I picked up in 2010 — a solid model at the time and I got a great deal, including two six-packs of digital video cassettes. Very soon after that, I got the first of many smartphones with better video cameras than this tape-based thing. Let’s just say that most of those tapes are still in their original packaging today.

Pondering that disappointing return on a seemingly good deal also reminded me of some mistaken stock investments over the years. I’m not perfect; Neither are you or Warren Buffett. That’s right — even legendary investing geniuses like the Oracle of Omaha make some bad calls. The trick is to learn something from each mistake and make slightly better decisions in the future.

On that note, let’s revisit one of my worst investments. This should be fun.

Doubling down on a doomed crypto investment

About one year ago, I saw the crypto-friendly bank Silvergate Capital teetering on the edge of financial ruin because of several scandals in the crypto sector and plunging digital asset prices.

I thought Silvergate’s services were unique and indispensable, and surely some deep-pocketed player would step in and save the bank’s financial bacon before it was too late. This regional bank was never “too big to fail,” but I certainly thought it was too important to meet a bad ending.

So I doubled down on a modest Silvergate investment instead of backing out. As it turns out, Silvergate’s services were helpful but not unique, and the crypto industry can function without them. The company shut down its operations, including that seemingly essential real-time payment network, and the stock took another deep dive. It’s still going to zero, slowly but surely.

What did I learn from the Silvergate ordeal? Let’s take a look.

Why did Silvergate look so special?

Looking back with the perfect 20/20 vision of hindsight, I kind of get what I was doing with Silvergate.

The big idea was that the Silvergate Exchange Network (SEN) provided a sorely needed service to most crypto-trading services. Closing it down would spell the end of real-time cash-to-crypto and crypto-to-cash transactions, especially on weekends end evenings. Silvergate’s management often presented itself as the only meaningful provider of this service, and I couldn’t imagine a cryptocurrency market without it.

Furthermore, I expected the crypto market to shake off the burden of industry scandals, rebuilding the cracked and charred reputation of digital asset investments in the long run. If Silvergate’s balance sheet looked shaky in early 2023, a fairly modest cash infusion from a larger bank, crypto-trading service, or hedge fund should have been enough to carry the company through a temporary crisis.

Oh, and Silvergate’s financial situation really didn’t look too dire to my insufficiently trained eyes. The company’s tier 1 capital leverage ratio was just 5.4% in the fourth quarter of 2022, down from 11.1% one year earlier and barely below the 6% minimum level regulators see as sufficient liquidity to operate a banking business. That should be close enough, right?

How did I miss this forest of red flags?

At the same time, the warning signs should have been painfully clear — and I didn’t really do my homework properly.

• Management comments don’t always tell the whole story. The SEN service already had a couple of rivals a year ago. Customers Bank (NYSE: CUBI) started its crypto-compatible instant payments service in 2021 and the Ripple (CRYPTO: XRP) crypto network can play a similar role, for example.
• Financial leverage ratios are complex beasts, and Silvergate’s falling tier 1 figure was much worse news than I expected. This bank really needed a helping hand — and nobody was willing to play that guardian-angel role amid the meltdown of several crypto-oriented banks.
• Bitcoin (BTC 3.27%) prices were indeed not stuck in the basement forever but the real climb didn’t start until October. Again, Silvergate couldn’t afford to wait that long, and it’s always a risky bet to assume crypto prices will do anything predictable and helpful on short notice.
• Unfortunately, this money-losing episode is a classic example of confirmation bias. I could have uncovered at least some of the red flags above with 10 minutes of research time, a strong cup of coffee, and the right mindset. Instead, I may have been looking for excuses to support my initial Silvergate investment, leading me to the wrong conclusions and an even worse end to a weak investment.

Lessons learned from the Silvergate mistake

I closed out my Silvergate position at a 99.1% loss. Ouch. Without the wrong-headed doubling down at a lower price, the loss would have stopped at (doing the math) 98.8%. All right. At least I had the good sense to keep my follow-up investments small.

Still, I don’t recommend trying to catch falling knives, especially when the second investment is based on a loose understanding of complex financial issues. You won’t find me betting on bank stocks after this embarrassing error, even if they seem to offer valuable and unique services to industries in my wheelhouse.

These days, Customers Bank and Ripple have largely taken over Silvergate’s former role in the cryptocurrency ecosystem. But I won’t pick up any Customers Bancorp shares to keep my exposure to the crypto sector’s nuts-and-bolts infrastructure, no matter what its tier 1 ratio might be. I have no business betting on bank stocks, so my crypto exposure should stay closer to the digital side of that sector.

So I’m sticking with actual Bitcoin tokens, some Bitcoin-based exchange-traded funds, and a modest interest in crypto-trading service giant Coinbase (NASDAQ: COIN) until further notice. It still feels strange to talk about “traditional cryptocurrency investments,” but there you go. These proven crypto bets have been profitable so far and I expect significant gains in the long run.

And unlike the Silvergate debacle, I am not swinging for the fences with seemingly undervalued companies in dire financial straits. Bitcoin looks like a solid inflation hedge in the long run and Coinbase is an industry giant valued at just 7 times free cash flows. I don’t see any falling knives on that list.