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With a handful of prominent companies already buckling under the economic fallout from the coronavirus, new research indicates that bankruptcies are set to rise even higher as debt-laden businesses succumb to the effects of COVID-19.

Given that U.S. GDP contracted by 9.5% in the first two quarters of 2020, the authors of a working paper, Sizing Up Corporate Restructuring in the COVID Crisis, set out to determine how many firms will fail, list the challenges those bankruptcies will present to courts and financial markets, and identify potential policy solutions.

To estimate the upcoming increase in financial distress, the researchers tracked the U.S. unemployment rate and the frequency of businesses going bankrupt from 1980 to the first quarter of 2020. (Historically, bankruptcies in the U.S. have closely tracked the unemployment rate.)

The researchers also forecast bond ratings downgrades and defaults and examined the impact of reduced revenues and profits on corporate balance sheets.

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

Based on a 9.2% unemployment rate in the fourth quarter of 2020 (as projected in September by the Survey of Professional Forecasters), the authors initially predicted that bankruptcies would finish the year 140% higher than they were a year ago, with the bulk yet to come.

Better news than anticipated on the unemployment front through the fall (but not most recently) might bring that number down a bit, saidDavid Thesmar,one of the studys co-authors and a professor of financial economics at MIT Sloan. But given the severity of the recession, it remains that by all metrics, corporate financial distress is set to increase, he said.

Many companies entered 2020 already carrying a heavy debt load, and this put them at a great disadvantage when COVID-19 hit, Thesmar said.

By all metrics, corporate financial distress is set to increase.

Some firms should have disappeared as the natural result of competition forces, but most firms will be failing because they just have too much debt, some of it born in COVID-19, Thesmar said.

U.S. corporations owed $10.5 trillion to creditors earlier this year by one estimate, a figure 30 times higher than it was half a century ago. A few of those companies that carried significant debt include Hertz as well as Neiman Marcus and J. Crew, which filed for bankruptcy this year.

The researchers expect more to follow, with smaller firms at greater risk.

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

This is especially worrisome as the balance sheets of small firms are hit the hardest by the current recession, the researchers wrote.

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

However, the authors suggested that the surge would be manageable: To keep the caseload to the level of the last crisis, in 2009, the authors estimated that the U.S. court system only needs an additional 250 more judges. Some retired judges could be recalled, they suggested.

If this is not done, courts will be crowded, and it will mostly hurt small firms. Thesmar said that as bankruptcy judges become busier, they tend to prioritize larger firms, making those more likely to be able to emerge from bankruptcy, whereas smaller firms are more likely be dismissed from court and left to liquidate without court protection.

The working paper presented a number of policy options that could help address some of the friction:

Despite the grim forecast, the current number of bankruptcies remains relatively low, with recent data indicating thatbankruptcy filings have slowed to a halt.

So far, there are very few failures, Thesmar said. Fewer than usual, actually.

Thesmar said that the CARES Act, the Paycheck Protection Program (PPP), the Main Street Lending Program, and the extension of unemployment insurance may have helped keep businesses afloat and out of bankruptcy. Economists have cited the benefits of these programs, noting that the PPP, for instance, provided much needed flexibility to small businesses by allowing them to apply for low-interest loans through their banks to cover some of their expenses. Unfortunately, the first round of federal loans allocated for small businesses didnt always reachthose who needed it most, other research showed.

Another round of assistance is necessary, Thesmar said. Without it, many businesses may have to close up shop.

Thesmar also said that while many companies have missed making their payments to creditors, theres been some evidence suggesting that lenders have been lenient, which has also helped companies avoid filing for bankruptcy. The authors cited a Census Small Business Pulse survey that 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 have willing to be lenient, many firms that have missed payments may avoid bankruptcy, at least in the short run, the authors wrote. If these factors are only temporary, low bankruptcy numbers seen so far are a period of calm before the storm. On the other hand, if these factors actually prevent financial distress for many firms, our forecasted number of bankruptcies could be too high.

Going forward, Thesmar said that debt holders should be flexible with businesses to minimize the damage and give firms more time to come up with doable 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 firms go under, and they will only reemerge slowly 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 the Harvard Business School and Benjamin Iverson of Brigham Young University-Provo.

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The coming wave of COVID-19 bankruptcies and how to mitigate them - MIT Sloan News