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As the COVID-19 crisis expands globally, the rising number of zombie companies could endanger financial stability.

The intensifying COVID-19 crisis will expose why covenants in leveraged loans are important.  Leveraged loan markets are in distress and this is spilling into collateralized loan obligation markets.

Today’s unemployment insurance (UI) data and the junk bond market sell-off are very negative macroeconomic and market signals that will adversely affect banks. Banks are lenders both to individuals and corporations, and they also invest in corporate bonds as well as in bonds called asset backed securities, which are pools of assets such as residential and commercial mortgages, credit card debt, and student loans. As individuals and corporations default on loans and bonds, banks’ profitability and capital levels will decrease substantially.

When we look back in a few months, this may very well be the week when it should be clear to all, that the coronavirus unemployment tsunami has begun. With thousands of restaurants, bars, hotels, and small businesses closing down voluntarily or due to state government executive orders, jobless claims are rising at unprecedented levels.  All sectors of the economy are vulnerable to varying degrees.

This week, labor data, market prices, and experts’ forecasts, are clearly showing that the coronavirus pandemic is causing an unprecedented synchronized, global economic shutdown. Ordinary people must be rescued now. Millions around the world are already feeling the pain of layoffs and reduced working hours.

When President Trump’s own U.S. treasury secretary talking about 20% unemployment unless legislators finally start implementing some type of fiscal stimulus, what more of a signal do you need to know that the U.S. is in trouble? We have not had 20% unemployment since 1935 during the Great Depression.

Significant vulnerabilities in the global leveraged loan and collateralized loan obligations (CLOs) markets have grown since the 2008 financial crisis, especially since there are numerous supervisory and data gaps in these markets. According to analysis in the just released report “Vulnerabilities associated with leveraged loans and collateralised loan obligations,” the Financial Stability Board found that “the degree of borrowers’ leverage has increased.” Moreover, “although loans tend to have lower credit ratings, there is some evidence that certain changes to loan documentation that weaken creditor protection are not fully priced in by market participants and investors.”

Foreign exchange and interest rate derivatives markets are bigger than ever before. This level of growth means investors and regulators should look carefully at the level of credit, market, liquidity, and operational risks these instruments pose.

Given the technology, data, and risk management challenges that I see almost on a daily basis at banks, I have to admit that I found the Federal Reserve report to be a lot more glowing than I would have expected. It took me until the bottom of page 13 to read “Large financial institutions are in sound financial condition, although nonfinancial weaknesses remain.”  Nonfinancial refers to pretty important things like data quality, information technology infrastructure, internal controls, model risk management, and governance.

Year-to-date, leveraged loan defaults stand at close to $23 billion. This level of defaulted debt is higher than the total for all of 2018. Just from October to November 22, 2019, eleven issuers have defaulted to the tune of $7.8 billion. This represents 34% of the total default dollar value this year.

Senators Sherrod Brown and Elizabeth Warren, as well as Representative Mark Pocan, are asking important questions about The Carlyle Group’s private equity investments in nursing homes and long-term care. Senator Warren and Representative Pocan are sponsoring S.2155 and H.R.3848, ‘Stop Wall Street Looting Act’ to “ close the legal, tax, and regulatory loopholes that have long allowed private equity firms to capture rewards of their investments while passing the risk on to target companies, investors, workers, and consumers.”

Nine Democratic members of congress sent a letter to consulting and accountancy firm, Ernst & Young (EY), questioning the methodology and results of a report on private equity firms contributions to the U.S. economy, that it published together with private equity industry group, American Investment Council (AIC). In their letter, Senators Elizabeth Warren, Bernie Sanders, and Tammy Baldwin, together with Representatives Mark Pocan, Jesús G. ‘Chuy’ García, Rashida Tlaib, Pramila Jayapal, Jan Schakowsky, and Ayanna Pressley expressed concern about the way that corporations can wield their influence.

Thousands of jobs have been lost at U.S. private-equity backed companies, and nowhere is this more acute than in the retail sector. In less than a decade, almost 600,000 retail jobs in private-equity backed companies have been lost. Additionally, over 700,000 jobs have been lost at suppliers and local businesses interconnected with those retailers, making the total number of people unemployed 1.3 million.

Private equity companies are not job creators.  In fact, private equity firms cause significant unemployment. All too often when private equity professionals tout their cost cutting strategies, they do not mention that cost cutting means firing people and taking away their livelihoods.

The significant rise in the stock market in the last few years has masked how private equity firms have really performed.  According to the private equity team of Bain and Company, an analysis of private equity deal results versus fund projections for 65 mature buyouts invested since the financial crisis, showed that over 70% of private equity deals fell short of their projected margins by an average of 330 basis points below forecasts.

The number of private equity backed companies, which credit ratings are in distress, has risen by almost 30% since last year. Distressed rated companies are those that are rated B- or worse and which also have a negative outlook.