Too important to fail? My misguided confidence in the resilience of the crypto bank is doomed to failure

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

One day, I was browsing through a desk drawer that I rarely revisit. There was a digital camcorder I picked up in 2010 – a solid model at the time and I got a great deal, including two sets of six digital video cassettes. Shortly 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 these tapes are still in their original packaging today.

Thinking about that disappointing return on a seemingly good deal also reminded me of some poor stock investments over the years. I am not perfect; Neither you nor Warren Buffett. It's true – even legendary investing geniuses like the Oracle of Omaha make some bad decisions. The trick is to learn something from every mistake and make slightly better decisions in the future.

In this regard, let's revisit one of my worst investments. This should be fun.

Double down on your doomed crypto investment

About a year ago, I saw a crypto-friendly bank Silvergate Capital It is teetering on the brink of financial ruin due to several scandals in the cryptocurrency sector and falling digital asset prices.

I thought Silvergate's services were unique and indispensable, and surely some wealthy player would step in and save the bank's financial bacon before it was too late. This regional bank was by no means “too big to fail,” but I certainly thought it was important that it meet a bad end.

So I doubled down on my modest investment in Silvergate rather than backing out. As it turns out, Silvergate's services were useful but not unique, and the cryptocurrency industry could do without them. The company shut down its operations, including a seemingly essential real-time payment network, and the stock took another deep dive. It's still heading to zero, slowly but surely.

What did you learn from the Silvergate ordeal? lets take alook.

Why did Silvergate seem so special?

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

The big idea was that the Silvergate Exchange Network (SEN) provided a much-needed service for most cryptocurrency trading services. Closing them will bring an end to real-time cash-to-crypto and crypto-to-cash transactions, especially on weekend evenings. Silvergate's management often presented itself as the only provider of this service, and I could not imagine the cryptocurrency market without it.

Moreover, I expected the cryptocurrency market to shake off the burden of industry scandals and rebuild the cracked and charred reputation of digital asset investments in the long term. If Silvergate's balance sheet looked shaky in early 2023, a fairly modest cash infusion from a larger bank, cryptocurrency trading service, or hedge fund should have been enough to pull the company out of a temporary crisis.

Oh, and Silvergate's financial situation didn't look too bad 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 ago and barely below the 6% minimum that regulators view 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 obvious, and I didn't do my homework properly.

• Management comments don't always tell the whole story. The SEN service already had a number of competitors a year ago. Customer Bank (NYSE: COBY) Cryptocurrency-compatible instant payments service launched in 2021 and ripple (Crypto: XRP) A cryptographic network can play a similar role, for example.
• Leverage ratios are complex beasts, and Silvergate's Tier 1 drop was much worse news than I expected. This bank really needed a helping hand — and no one was willing to play the role of guardian angel amid the collapse of several cryptocurrency-oriented banks.
• Bitcoin (BTC 2.25%) In fact, prices weren't stuck in the basement forever, but the real rally didn't start until October. Again, Silvergate couldn't wait that long, and it's always risky to assume that cryptocurrency prices will do anything predictable and beneficial 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, a cup of strong coffee, and the right mindset. Alternatively, I may have been looking for excuses to back up my initial investment in Silvergate, leading me to wrong conclusions and an even worse ending for a poor investment.

Lessons learned from the Silvergate mistake

I closed my Silvergate position with a loss of 99.1%. Oh. Without the false double at a lower price, the loss would have stopped at (do the math) 98.8%. Good. At least I had the common sense to keep my follow-on investments small.

However, I do not 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 mistake, even if they appear 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 wouldn't pick any Bancorp client stocks to maintain my exposure to the underlying infrastructure of the cryptocurrency sector, regardless of the Tier 1 ratio. I have no business betting on bank stocks, so my exposure to cryptocurrencies will have to remain closer to the digital side of the sector.

So I'm sticking with actual Bitcoin tokens, some Bitcoin-based ETFs, and a modest interest in the cryptocurrency trading services giant Coinbase (NASDAQ: Currency) until a further notice. It's still strange to talk about “traditional cryptocurrency investments”, but that's the way it is. My proven crypto bets have been profitable so far and I expect big gains in the long term.

In contrast to the Silvergate debacle, I am not swayed by companies that appear undervalued and are in dire financial straits. Bitcoin looks like a solid long-term inflation hedge, and Coinbase is an industry giant worth just 7 times free cash flow. I don't see any knives falling on that list.