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When you go deep enough into investment finance you start to get into philosophical questions. One that will inevitably come up is: “Have I lost money on an investment that I have not sold?” There are plenty of ways to think about this query. On one hand you can posit that unrealized losses are still losses because you could have used that money for something else. For this reason the idea of opportunity costs is deeply ingrained in the investment mindset. But you could also take the other side because technically the investment period has not come to an end so there is no use in worrying about the hypothetical losses.
Most reasonable people would probably say that the first answer, the one that takes into consideration unrealized losses, is the obvious one. But when it comes to accounting we have made a decision to adhere to the second option, for a lot of reasons. Having to think about unrealized losses is painstaking. Not only does it take an emotional toll (no one likes thinking about how much they lost), it is also a logistical nightmare. What is the value of the asset? How do you know that is the value? How often should you keep re-assessing the value?
Another reason to not consider unrealized losses is that it would force us to have to consider unrealized gains as well. Taxes on these unrealized gains would likely follow. Last March the Biden administration floated the idea of taxing unrealized gains for households worth at least $100 million. Almost the entire capitalistic community came out against this proposition, saying that it was not fair, un-American, and that it would tank our entire economic system.
While we don’t assess taxes on unrealized gains, there are accounting rules that require that companies show unrealized losses on their balance sheet to help investors understand the health of their company. But those rules don’t apply to every asset. This incongruence has become a talking point as analysts are keeping an eye on Charles Schwab after it moved a $189 billion of its investment in treasury notes from “available-for-sale” to “held-to-maturity.” This change in distinction allows the company to not report its unrealized losses since holding these bonds to maturity would not recognize losses at all. Silicon Valley Bank had categorized their bond investments the same way, which was one of the reasons why so many were surprised by the bank’s eventual failure after it sold its bonds in a bid to stay solvent.
Back in 2011 the Financial Accounting Systems Board had a proposal to switch to a “fair market” or “mark to market” approach that would require banks to disclose the change in value of their assets and loans. This was met by harsh criticism by the banking industry and resulted in over 2,800 comment letters. Eventually the idea was scrapped and the finance world moved on. Now there are more calls to renew this push and change how asset value is reported.
Reporting on unrealized losses would be more fair to investors but it would also likely tank the commercial real estate industry. Many commercial properties are losing value right now but banks that have loans out on them are happy to not have to consider these losses. Everyone is hoping that the market will bounce back and/or interest rates will go back down before refinancing is needed so no harm will be done. If we did have to re-evaluate the fair value of commercial properties, even the banks that are lending right now would probably not be able to justify the risk of offering new debt on an asset class that is losing value.
What commercial properties have going for them is that they are hard to value. Unlike bonds which have a market price set by an exchange, building value is subjective and therefore hard to pin down. Even if extra reporting on fair value was needed, banks and owners would probably find a way to prove that prices have not moved much. Tanking the financial system is never a good political policy so I doubt we will see any major moves to change how unrealized losses are reported. But if we do, I think one of the biggest impacts would be to the owners and lenders of commercial real estate.
Overheard
Mapped
There are a lot of misconceptions about how much each country taxes its citizens and corporations. Here is a map that shows each country’s total tax revenue as a percentage of their GDP.
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