With a handful of leading companies already fearful of the economic fallout from the coronavirus, new research indicates bankruptcies are set to increase further as indebted companies succumb to the effects of COVID-19.

Given that US GDP contracted 9.5% in the first two quarters of 2020, the authors of a working paper, “Assessing corporate restructuring in the COVID crisis”, Aimed to determine the number of companies that will fail, to list the challenges that such bankruptcies will present to the courts and financial markets, and to identify potential policy solutions.

To estimate the upcoming increase in financial distress, researchers tracked the unemployment rate in the United States and the frequency of business bankruptcies from 1980 to the first quarter of 2020. (Historically, bankruptcies in the United States have closely monitoring the unemployment rate.)

Researchers also predicted bond downgrades and defaults and examined the impact of falling income and profits on corporate balance sheets.

Their findings: The impact of COVID-19 on corporate profits and revenues has so far been comparable to the worst quarter of the 2008-2009 financial crisis.

Based on an unemployment rate of 9.2% in the fourth quarter of 2020 (as predicted in September by the Survey of Professional Forecasters), the authors initially predicted that bankruptcies would end the year 140% higher. than a year ago, the majority being yet to come.

Better news than expected on the unemployment front until the fall (but not the most recently) might bring that number down a bit, saidDavid Thesmar, one of the co-authors of the study and professor of financial economics at MIT Sloan. But given the severity of the recession, the fact remains that “in all respects, the financial distress of businesses is set to increase,” he said.

Heavy debts

Many companies have already entered 2020 with heavy debt loads, which put them at a great disadvantage when COVID-19 hit, Thesmar said.

“Some businesses should have gone as a natural result of competitive forces, but most businesses will fail because they simply have too much debt, some of which arose in COVID-19,” Thesmar said.

US companies owed $ 10.5 trillion to creditors earlier this year by an estimate, a figure 30 times higher than half a century ago. A few of these companies that have incurred significant debt include Hertz as good as Neiman Marcus and J. Crew, which filed for bankruptcy this year.

Researchers expect more to follow, as small businesses are more at risk.

The reason: large companies usually file for bankruptcy to restructure and settle new terms of repayment of their debts so that they can remain open; small and medium-sized enterprises very rarely restructure.

“This is all the more worrying given that the balance sheets of small businesses are the hardest hit by the current recession,” the researchers wrote.

Crowded lots and struggling businesses

The authors warned that if historical trends repeat themselves, a massive number of bankruptcies looms on the horizon. The courts will be stretched and the backlog of judges will increase.

However, the authors suggested that the increase would be manageable: to keep the workload at the level of the last crisis, in 2009, the authors estimated that the US justice system only needed 250 additional judges. Some retired judges could be recalled, they suggested.

If this is not done, the courts will be overcrowded and that will hurt especially small businesses. Thesmar said that as bankruptcy judges get busier, they tend to prioritize large companies, making them more likely to come out of bankruptcy, while small companies are more likely to be. dismissed from court and liquidated without judicial protection.

Policy proposals

The discussion paper presented a number of policy options that could help resolve some of the friction:

• Encourage amicable restructuring with payment moratoria and debt restructuring subsidies. The private sector is best placed to restructure debt, the authors write. Given their healthy balance sheets, banks can afford it, but subsidies, such as those suggested by Greenwood and Thesmar (2020), will lubricate the cogs of the process.
• Increase the number of judges available to handle cases.
• Facilitate debtor-in-possession financing to facilitate the restructuring of small and medium-sized businesses in court.

The calm before the storm?

Despite the gloomy predictions, the current number of bankruptcies remains relatively low, with recent data indicating that bankruptcy filings slowed.

“So far there are very few failures,” Thesmar said. “Less than usual, in fact.”

Thesmar said the CARES Act, Paycheck Protection Program (PPP), Main Street Lending Program and the extension of UI may have helped keep businesses afloat and avoid bankruptcy. Economists have cited the benefits of these programs, noting that PPP, for example, provided much needed flexibility for small businesses by allowing them to apply for low-interest loans from their banks to cover some of their expenses. Unfortunately, the first wave of federal small business loans did not always reach those who needed them most, other research has shown.

Another round of assistance is needed, Thesmar said. Without it, many businesses may have to go out of business.

Thesmar also said that while many companies have failed to pay their creditors, some evidence suggests lenders have been lenient, which has also helped companies avoid filing for bankruptcy. The authors cited a Census Small Business Survey this showed that 11.5% of all small businesses had missed a loan payment by the first week of May, while 23.6% had missed other payments, such as rent.

“If lenders are willing to be lenient, many companies that have defaulted on their payments can avoid bankruptcy, at least in the short term,” the authors wrote. “While these factors are only temporary, the low number of bankruptcies observed so far is a period of calm before the storm. On the other hand, if these factors are really preventing the financial difficulties of many companies, our expected number of bankruptcies could be too high. “

A way forward

Going forward, Thesmar said debt holders should be flexible with businesses to minimize damage and give businesses more time to make workable plans. Some economists have said that giving small businesses a little more flexibility can go a long way.

If a business is financially sound, “debt holders should agree to reduce the amount owed,” Thesmar said. “Something is better than nothing. The risk is that too many viable companies fail and only slowly reappear and slow down the recovery.”

The working paper, which was prepared for the Brookings Papers on Economic Activity, was co-authored by Robin Greenwood of Harvard Business School and Benjamin Iverson of Brigham Young University-Provo.