Bank Stocks – The Truth About Unrealized Losses

If you’ve been following the banking crisis that’s unfolded over the last month, there’s a good chance you’ve heard about “unrealized losses.” An unrealized loss is a decline in the price of a security that you haven’t sold. For banks, unrealized losses can eat into the amount of liquidity that they have to cover potential withdrawals.

Unrealized losses got a lot of publicity in the 2023 banking crisis. Many of the banks that failed, such as Silicon Valley Bank (OTC:SIVBQ), were stuck with large amounts of unrealized losses that left them incapable of handling withdrawal requests. The end result was that when clients rushed to take out their cash, the banks couldn’t come up with the money to pay them off. As a result, they failed.

Unrealized losses became a big part of the discussion about bank failures in the media. Many outlets reported on the levels of unrealized losses at U.S. banks, which supposedly stood at $620 billion after SVB failed. This seemed to have driven home in some investors’ minds that unrealized losses were the single biggest predictor of bank failures, as banks with a lot of such losses saw their shares fall around the same time the reports came out.

It is true that unrealized losses can contribute to liquidity issues at banks. However, what really matters is how much liquidity is left after you subtract unrealized losses from the reported values of the securities suffering losses. If the liquidity is still high, even after the unrealized loss is subtracted, then the bank is relatively safe. In this article I will make the case that it’s liquidity, not unrealized losses, that primarily determines whether a bank is at risk of going under.

What Are Unrealized Losses?

An unrealized loss is a decline in the price of an asset that you haven’t sold yet. For example, if you buy $100,000 worth of a $100 stock, and the stock price declines to $80, you have a $20,000 unrealized loss. If you sell the stock, you have a $20,000 realized loss. Upon realizing a loss, it becomes a taxable trade, which you can use to lower your taxes.

From the perspective of personal income taxes, unrealized “losses” are not really losses at all, but when it comes to corporate finances-especially bank finances-it’s a different matter entirely. When they report their earnings to the public, companies have to report unrealized losses as if they were realized losses-in other words, they count as losses that reduce net income. This may seem counterintuitive, and Warren Buffett thinks it’s wrong, but mark to market accounting helps investors keep an eye on asset values, in a world where analysts arguably focus too much on the income statement and not enough on the balance sheet.

The matter of unrealized losses is particularly important for banks. Banks are highly leveraged entities whose liabilities (mainly deposits) can be called in at any given moment. A depositor holding a checking or even a savings account does not need to wait for a maturity date to claim their cash, they can do it whenever they want to. One exception is with term deposits, which do have maturity dates, but in general, money in savings accounts can be withdrawn at any time.

For this reason, banks need lots of liquidity on their books. They almost never have the cash needed to pay off all their depositors, but they should have enough in cash and marketable securities combined to pay off at least 50% of them. If they have that much liquidity they are likely to be able to meet most of the withdrawal requests they receive.

Unrealized losses create a problem because they make liquid assets less valuable. Let’s say you’re a bank with $100 in deposits, $20 in cash and $80 in securities. With this much liquidity you can pay off all of your depositors no problem. However, if those $80 worth of securities decline in value to $60, you suddenly have a $20 shortfall. Now, having 80% of your deposits covered by liquid assets is actually quite good, because depositors don’t typically withdraw all of their money all at once. However, large numbers of withdrawals can occur pretty quickly (see for example the Silicon Valley Bank situation), so it is ideal for banks to have a large percentage of their deposits covered by liquid assets.

Now, if you followed along with the above, you’ll have noticed that it’s not unrealized losses in themselves that count, but how those losses affect overall liquidity. A bank with a large amount of unrealized losses and lots of liquidity after those losses are subtracted from the carrying amounts of held-to-maturity securities, is better off than a bank with no unrealized losses but no liquidity. To return to our “bank with $100 in deposits” example: even with its $20 in unrealized losses, it still has enough liquidity to cover 80% of its depositors. Now let’s imagine you have another bank: this one has $100 in deposits, $50 in cash and $20 in securities, which have never declined in price. This bank has no unrealized losses at all, but its liquidity coverage is actually worse than the former bank, which has a $20 unrealized loss. It’s what’s left after unrealized losses that counts, not the raw numerical amounts of unrealized losses.

Banks With High Unrealized Losses Can Still be Liquid

To illustrate how banks with large amounts of unrealized losses can still be very liquid, we can turn to two popular examples: Bank of America (BAC) and Charles Schwab (SCHW). Both of these banks have large amounts of unrealized losses, yet both are very liquid. In a recent article, I showed that Schwab had:

• $158.9 billion in fair value HTM securities.

• $147.8 billion in AFS securities.

• $40.1 billion cash.

• $366 billion in deposits.

In other words, Schwab has 94.7% of its deposits covered by liquid assets that are not committed to be used in any way. That is actually an extremely large amount of liquidity. Perhaps, if Schwab sees a lot of withdrawals, it will have to turn some of its securities into cash, which will reduce its profits-securities are a source of returns for banks. But this is a profitability issue only, not a bank failure issue.

It’s a similar situation with Bank of America. At the end of 2022, it had:

• $230 billion in cash.

• $220 billion in AFS securities.

• $524 billion in HTM securities when adjusted down to fair value.

• $1.9 trillion in deposits.

So, we’ve got enough liquidity here to cover 51.2% of deposits. Not quite as good as Schwab, but still very strong. Bank of America would need half of its depositors to withdraw all at once in order to be at risk of failure. When you consider that some of BAC’s account holders are in CDs rather than conventional savings accounts, that appears unlikely to happen.

Now, there is the matter of how Schwab and Bank of America will fare in terms of profit. The more people withdraw their money, the lower these banks’ cash position, and the lower their CET1 ratios. A bank’s CET1 ratio partially determines how many loans it’s allowed to make, so a lot of withdrawals can hurt profits. However, Bank of America has been beaten down so badly it’s now below its book value, while Schwab was growing earnings at 23.6% in the trailing 12 month period. These stocks both have things going for them: value in BAC’s case, growth in SCHW’s case.

The Bottom Line

The bottom line on unrealized losses is that they can be an issue for banks but they are not, in themselves, fatal. What really matters is how much liquidity is left after you adjust for the unrealized losses. Charles Schwab and Bank of America both score well in that regard, and many other banks are in the same boat.