Halloween Candy and Unrealized Losses
I grew up in suburban St. Louis, and every single house gave out Halloween candy.
My bag was completely full in 20 minutes.
You’d go from one door to the next, and it felt like stealing- I can’t believe how EASY this is!
Obviously, you didn’t know what candy you got until the end of the night. That relates to unrealized losses on assets, which I’ll get to in a minute.
We have a Halloween tradition in St. Louis: kids are asked to tell a joke when they trick or treat.
The payoff
The payoff is when you get home, dump the candy on the floor, and see what you got. I have always been partial to Reese’s (hoping we have some left after Halloween this year).
Of course, you do get that health-conscious family that hands out apples- just plain apples.
There’s no way to know what you’re getting- which brings us to unrealized gains and losses.
Realized vs. unrealized gains and losses
You need a buy and a sell transaction to generate a realized gain or loss.
Let’s say that you buy 100 shares of Apple common stock at $25 per share and sell the 100 shares at $40. The per-share gain is $15 dollars per share, and your total realized gain is ($15 X 100 shares), or $1,500.
If you sell the 100 shares of Apple for $18 per share, you have a realized loss of ($25 cost - $18 sale price), or $7 X100 = $700 realized loss.
An unrealized gain or loss means you have a buy- but no sell yet.
If Apply stock went to $40 and you didn’t sell, you’d have a $1,500 unrealized gain. Same thing with a loss: If the stock price went down to $18 and you held the Apple stock, the unrealized loss is $700.
When a business owns investments, they often must disclose unrealized losses to financial statement readers.
Disclosing unrealized gains and losses
A 10/17/23 quote from Reuters:
“Bank of America (BAC.N) reported unrealized losses of $131.6 billion on securities in the third quarter but the bank does not expect the portfolio will generate actual losses in the long-term.”
That number looks staggering, but keep in mind that BAC has $3.1 trillion in assets.
Plus, BAC categorizes the assets as held to maturity securities. These are bonds that have a fixed maturity date, and mature at the original face value. If you buy a $1,000 face amount bond and hold it until maturity, a $1,000 is repaid to you.
A quote from the CFO:
"All of these are unrealized losses are on government- guaranteed securities. Because we're holding them to maturity, we will anticipate that we'll have zero losses over time."
So, using the Halloween candy analogy, it sounds like BAC will get all of the bond principal repaid- financial statement readers know what’s in the bag.
Why is there a focus on unrealized gains now?
Two reasons: Silicon Valley Bank and higher interest rates
You probably remember the SVB crisis:
“Unrealized losses have come under closer scrutiny by investors since March. At the time, Silicon Valley Bank (SVB) sold a portfolio of its holdings at a sharp loss, precipitating its collapse and fueling the worst industry turmoil since the 2008 financial crisis.”
In addition, interest rates have increased sharply, meaning that all outstanding bonds are worth less.
Assume that BAC owns 2% 10-year treasury bonds. As of this writing, current 10-year T-Bonds are being issued at 4.7% (with rounding). The 2% treasury prices have declined, because investors can now get 4.7% coupon rates.
The bottom line?
Sometimes a business has to sell bond investments that they intended to hold until maturity. In the case of SVB, they had to sell bonds to pay depositors when billions of dollars were leaving the bank.
SVB incurred huge realized losses.
The lesson
Just because a business intends to hold bonds until maturity doesn’t mean it will always work out that way. SBV held a fire sale- to put out a financial fire.
Pay attention to unrealized losses- know what’s in your Halloween candy bag.