Southwest Economy 4Q-2011

8/3/2019 Southwest Economy 4Q-2011

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F E D E R A L R E S E R V E B A N K O F D A L L A S

SouthwestEcono

In This Issue

On the Record:Dodd–Frank: Toward Greater FinancialSystem Stability

Private EquityIndustry: SouthwestFirms Draw onRegional Expertise

Spotlight: TexasEmployment Gains Aren’tSimply a Low-Wage JobsStory

Fourth quarter 2011

In This IssueStates Still Feel Recession’sEffects Two Years

After Downturn’s End



President’sPerspective

I we have not eradicated

too big to ail rom our

nancial in rastructure

with the myriad rules and regulations we are writing

and implementing,

nancial re orm and

stability will have eluded

us yet again.

The Dodd–Frank Wall Street Re orm andConsumer Protection Act—one o the most sig-

ni cant responses to the nancial crisis—wassigned into law a little more than a year ago.The act establishes a new regulatory in rastruc-ture or promoting nancial stability.

Dodd–Frank mostly provides high-leveldirection, leaving critical decisionmaking anda number o details to regulatory discretion.Many o its most prominent eatures, includingthe Financial Stability Oversight Council andnew Federal Reserve responsibilities oversee-ing some nonbank nancial companies, areexplained in greater detail by Dallas Fed Exec-utive Vice President Robert D. (Bob) Hankins

in the “On the Record” eature in this issue o Southwest Economy .

A primary purpose o Dodd–Frank is end-ing “too big to ail.” During the recent nan-cial crisis, when smaller banks got into deeptrouble, regulators generally took them over.

Failing big banks, however, were allowed to lumber on with government sup-port, despite extensive allout. Big banks that gambled and generated unsustainablelosses received a huge public bene t: too-big-to- ail support.

As a result, the most imprudent lenders and investors were protected rom theconsequences o their decisions. This strikes me as counter to the very essence o competition that is the hallmark o American capitalism. In cra ting Dodd–Frankmandates, we need to restore market discipline in banking and let the marketmete out its own brand o justice or excessive risk taking, rather than prolong theinjustice o too big to ail.

We still have work to do. The top 10 banking institutions now account or 65percent o banking assets, substantially more than the 26 percent o 10 years ago.

When it comes to these largest institutions, we must apply Dodd–Frank extensively and vigorously. I we have not eradicated too big to ail rom our nancial in rastructure with the myriad rules and regulations we are writing and implementing,

nancial re orm and stability will have eluded us yet again.I trust regulators will rise to the challenges posed by the nancial crisis and too

big to ail. By doing so, we will leave a legacy o success and unctional in rastruture or next-generation supervision and regulation.

Richard W. Fisher President and CEO

Federal Reserve Bank o Dallas


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States Still Feel Recession’Two Years After Downturn

By Jason Saving

The nation ultimately is the sum o its parts and cannot

all into a serious recession

without it a ecting most

states and their nances.

The U.S. economy entered a nancial-market-driven recession in December 2007

rom which it has yet to ully recover. Theboom o the mid-2000s has been replaced

with a stubborn national reality o high un-employment and sluggish output growth,

with no clear indication when economicactivity will return to more normal levels.

Yet the states have, in many ways, borne

the brunt o the recession. Demand or publicservices increased at the very moment taxrevenue—especially rom property taxes—de-clined. As late as this October, a ull two yearsa ter the recession ended, states rom Floridato Cali ornia to New York warned o newshort alls that must be addressed throughspending cuts and tax increases. In Texas,lawmakers completed work on cuts totalingat least $15 billion or the upcoming two-yearbudget cycle.

As the nation’s economic woes contin-ued, the ederal budget de cit climbed, pos-

ing potential limits on aid Washington couldprovide. The de cit soared to $1.4 trillion in2009 and is expected to remain above $1 trillion annually until 2013. At least one majorratings agency downgraded the country’stop-tier credit rating, warning as part o itsunprecedented action that o cials must domore over the short term to stabilize and im-prove the de cit picture. Other ratings rmshave similarly cautioned that their assess-ments o U.S. creditworthiness could be cut

scal imbalances aren’t addressed.

How Have States Done?Following the 2001 recession, state

budget outlooks improved. A ter postingcollective budget gaps o about $80 bil-lion in 2003 and 2004, scal retrenchmentcoupled with above-average economicgrowth virtually eliminated short alls by mid-decade. Even in the rst ull year o the most recent recession, 2008, it appeare

states might weather the national economistorm relatively unscathed.Un ortunately, the nation ultimately i

the sum o its parts and cannot all into aserious recession without it a ecting mosstates and their nances. On the revenueside, job losses and wage cuts reduced ind

vidual income and consumption, crimpingstate revenue. And at the very moment revenue ell, residents beset by poor economiconditions increased their demand or anarray o state-provided social services raning rom Medicaid to job training, drivingup expenditures beyond projections. Theresult: a dramatic widening o state scalgaps.

The depth o the recent recessionis vividly illustrated by ballooning statede cits in 2009–11, which produced anunprecedented three consecutive years o more than $90 billion short alls (Chart 1 ).In 2010 alone, 43 states con ronted a cumlative $174.7 billion budget hole—the largest ever recorded. And while those de citsnarrowed somewhat in 2011, they are not

Chart 1State Short alls Reach Record $174 Billion in 2010Billions o dollars

0

20

40

60

80

100

120

140

160

180

200

201320122011201020092008200720062005200420032002

Estimates Projections

SOURCE: National Con erence o State Legislatures.


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expected to return to prerecession levels orat least two years amid the relatively weakeconomic recovery.

With balanced budgets required in 49o the 50 states by law or state constitu-tion, jurisdictions coming up short must cutservices (or raise taxes) to bring spendingplans into balance. To be sure, budgetary tricks— or example, strengthening near-term economic assumptions or making

avorable assumptions about social-servicecaseloads—can sometimes so ten the blow.These devices can only go so ar, ensuringthat some sacri ces will be required.1

But were those measures limited to un-necessary and little-used programs, or didstates reduce unding to key budget areas,such as health and education?

In 2010 (the last year or which dataare available), 43 states reduced unding orhigher education, according to the National

Association o State Budget O cers (Chart

2 ). This coincided with a period when out-o -work individuals increasingly turned tocolleges or occupational retooling. Somestates also enacted policy changes to re-duce support or higher education over thelonger term, continuing a trend seen overthe past ew decades.

A slightly less common target wasK-12 education, which 34 states cut in

scal 2010 (October 2009 to September2010). The reductions coincided with de-bate over whether class sizes had become

too large and student test scores too low.Since a majority o most states’ outlays goto education and health, substantial budgetcuts cannot— rom a purely mathematicalperspective—occur without a ecting ei-ther item. Typically, such reductions are atleast partially restored in later years as theeconomy improves. The 2007–09 recession’sa tere ects have lingered longer than many expected, perhaps delaying by several yearsthe reinstatement o unding.

Public health programs were pared in31 states; support or the elderly and disabled

was trimmed in 29. These cuts revealed aparadox. States, while well-positioned to helpindividuals when most citizens (and the taxbase) are healthy, struggle to o er their stan-dard menu o bene ts when widespread andpervasive economic shocks increase the num-ber o people needing assistance.

The di culty could be mitigated by giv-ing states more leeway to incur de cits. But,as has become evident at the ederal level,de cit spending can create problems o itsown, at least over the medium to long term.

What About Texas? As a majority o state economies en-

tered recession in late 2007, Texas contin-ued growing (Chart 3 ). And as most stateeconomies emerged rom recession in2009–11, Texas outper ormed the remain-der o the country in employment growthby a ull percentage point—about equal toTexas’ historical advantage over the past

ew decades.

Texas’ avorable per ormance stemsrom a number o actors, including its o

and gas industry, a low cost o living, avable demography, restrictive home-lendinglaws, an attractive business climate and ahousing sector that held up better than itdid elsewhere. These items do not and cannot guarantee growth here will exceed thato the nation—Texas trailed the U.S. in 10o the 86 quarters depicted in Chart 3, or

Chart 3Texas Exceeds Nation in Job GrowthQuarter/quarter percent change*

20102008200620042002200019981996199419921990

U.S.Texas

–8

–6

–4

–2

0

2

4

6

* Seasonally adjusted annualized rate.

SOURCES: Bureau o Labor Statistics; Texas Work orce Commission; Federal Reserve Bank o Dallas.

Chart 2Most States Cut Health, Education, Other Areas in 2010Number o states

0

5

10

15

20

25

30

35

40

45

50

Govt. workforceHigher educationK-12 educationElderly/disabledPublic health

SOURCE: National Association o State Budget O fcers.


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example. But they do suggest that, otherthings being equal, Texas economic activity should be at least slightly stronger than thenational average.

Despite this relatively avorable envi-ronment, Texas entered the 2012–13 bud-geting biennium with a short all o between$15 billion and $27 billion, depending onthe spending baseline chosen.2 This gaprepresents about 10 percent o state spend-ing and 1 percent o economic activity overthe two-year cycle. In light o the $3 bil-lion to $4 billion in debt accumulated by the ederal government daily, roughly $20billion over two years may not seem espe-cially signi cant. But it is a large amountin a state that o ers little assistance to thepoor and prides itsel on a business- riendly (read: small and e cient) tax and regula-tory regime. (See accompanying box. )

The Legislature passed and the gov-ernor signed a $172.3 billion budget or

scal 2012–13—about $10 billion below

the previous two-year budget and $15 bil-lion less than actual 2010–11 expenditures.Each spending category depicted in Chart2 was cut, with an especially large propor-tion borne by health services. A variety o elements prevented even larger reductions.These included increased revenue rom arecovering state economy, a larger-than-ex-pected withdrawal rom the state’s rainy-day

und and just under $5 billion in “nontaxrevenue enhancements” such as higher li-cense and registration ees.

Downgrading Debt? As i state budget cuts were not

enough, questions about excessive stategovernment indebtedness have arisen. Fol-lowing S&P’s downgrade o U.S. borrow-ings, ratings rms said debt-ridden statesmight themselves be lowered in the near

uture—as Nevada and New Jersey wereearlier this year and Cali ornia was in 2010.Texas, however, has not been cited as a

As most state economies

emerged rom recession in

2009–11, Texas outper ormed

the remainder o the country in

employment growth by a ull

percentage point—about equal

to Texas’ historical advantage

over the past ew decades.

How Dependent Is Texas on Federal Funding?Texas has signi cantly trailed the national average in ederal spending per capita since the late 1980s

and has been somewhat below the national average in ederal spending per tax dollar paid to Washington.This means the Texas economy isn’t as dependent on ederal spending as the typical state and receives less

or its contributions.In 2005—the latest year or which complete data are available—Texas received roughly $6,500 per

person in ederal outlays, compared with a national average o $7,600. The Texas gure is 86 percent o the

national average and places the state 42nd out o 50 in per capita ederal unding.Another way to address the conceptual question o Texas’ dependency on ederal unding is to exam-

ine ederal aid to state governments themselves, a narrower but somewhat less volatile measure o ederalsupport or a region. Here the answer is similar: Texas received $1,179 per person, compared with thenational average o $1,460, putting it in 43rd place.

This makes Texas somewhat o an outlier in its “neighborhood.” New Mexico routinely receives largerper capita ederal outlays than any other state, or example—about 50 percent more than Texas. Louisiana isalso somewhat above the national average, receiving about 15 percent more than its much larger neighbor.

What about stimulus unding? Might it be that Texas has received an infux o unding whose suddenwithdrawal would cause hardship relative to other states?

It turns out that o cial government data on stimulus unding by states are broadly consistent with

other outlay data. To date, Texas has been awarded $674 per person in stimulus-related contracts, grantsand loans rom the ederal government. While this puts Texas in second place among the states in totaldollars received, Texas ranks 48th on a per capita basis, behind only Florida (whose governance resemblesTexas’ in many respects) and New Jersey. The bottom line: Texas is not disproportionately dependent onstimulus monies.

One nal issue concerns the possibility o a downgrade to Texas’ credit rating i the nation’s credit-worthiness were reduced. Texas is currently one o 15 states to boast a top-tier rating rom Moody’s, orexample. Five o those 15 were recently placed on a downgrade watch and would ace a likely cut i therewere a technical de ault by the U.S. But Texas was not one o the ve, in part because it is less dependent on

ederal unding. So while the possibility o a state downgrade cannot be ruled out, there are ew indicationsit will happen in the near term.


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downgrade candidate. How do its debt lev-els compare with those in other parts o thecountry?

Such a comparison would generally use per capita state debt. Over the past twodecades, per capita state debt shows Texasat about one-third the debt level o the resto the nation (Chart 4 ). In 1993, or exam-ple, Texas incurred per capita state debt o $478 versus $1,576 or the remainder o thenation. In 2009, the last year or which data

are available, the comparison was $1,228 versus $3,599.

However, Texas has historically en-abled localities—cities, counties and schoodistricts—to undertake unctions that else

where might be done (or at least paid or)by the state. This suggests that a more valicomparison would need to include local as

well as state debt.In terms o state and local per capita

debt, Texas essentially tracked the rest o

Chart 5Texas Mirrors Rest o Nation in State and Local Per Capita DebtThousands o dollars

0

1

2

3

4

5

6

7

8

9

10

Rest of U.S.

Texas

20092008200720062005200420032002200120001999199819971996199519941993

SOURCES: Bureau o the Census; U.S. Treasury.

Texas has historically enabled

localities—cities, counties and

school districts—to undertake

unctions that elsewhere might

be done (or at least paid or)by the state.

Chart 4Texas Trails Rest o Nation in State Per Capita DebtThousands o dollars

0

1

2

3

4

Rest of U.S.

Texas

20092008200720062005200420032002200120001999199819971996199519941993

SOURCES: Bureau o the Census; U.S. Treasury.



the nation over the past two decades, witha slight uptick over the past several years(Chart 5 ). This suggests that looking at stategovernment data alone may provide a mis-leading impression o the extent to whichTexas is a small-government state. Rather,Charts 4 and 5 illustrate what economistssometimes call “ scal ederalism”—the del-egation o responsibilities to the smallest gov-ernment unit able to carry them out. (Floridais also notable in this regard.)

Such a structure is neither inherently desirable nor inherently undesirable on eco-nomic grounds alone. On one hand, delegat-ing tasks to localities can help governmentbetter tailor the services it provides to theneeds o individual communities and may improve e ciency by making civil servantsmore accountable to their constituents. Onthe other hand, it can exacerbate income in-equality by impeding revenue-sharing acrossjurisdictions and perhaps reduce economies

o scale that larger jurisdictions may produce.There is some economic evidence that em-powering localities can boost state economicgrowth, though both state and local debt pat-terns must be considered when this is done.

States have an additional key liability not captured by debt-issuance gures: thedegree to which their pension programs areunder unded. Any time a jurisdiction makespension promises to its workers withoutadequately setting aside revenue streamsto pay or them, uture taxpayer liabilities

are created, even though these promises donot immediately increase measured statedebt. Media reports have revealed states

with large and under-recognized scal gapsin their pension systems. That liability willeventually swamp the rest o their debt andrequire very large scal adjustments. Mightthis be true or Texas?

Chart 6 illustrates the extent to whichthe continental states have adequately undedtheir pension systems. Nineteen states, includ-ing Texas, were at least 80 percent undedin both 2008 and 2009, a benchmark orsustainable pension systems. In those states,relatively modest scal adjustments shouldbe enough to maintain solvency over themedium to long run. Nineteen other states

ell below the 80 percent threshold in both years, sometimes by a signi cant margin. Inthose states, considerable adjustments may eventually be necessary, whether they comein the orm o reduced bene ts or higher tax

revenues, or both. The remaining 10 states allbetween these two extremes.Texas doesn’t appear to be an outlier

when it comes to government debt and un-unded pension liabilities.

Meeting Service NeedsState nances have eroded consider-

ably over the last ew years, leading tocutbacks across wide swathes o programareas nationwide. Texas joined this groupin the 2012–13 budget cycle, addressing a

$15 billion to $27 billion short all almostexclusively through expenditure reduction

Across the country, state debt issu-ance has risen in recent years. Texas has

ollowed suit, though its overall borrowinlevels and un unded pension liabilities lie

well within national norms.Provided the nation does not all back

into recession, state short alls are expecteto gradually recede toward more usuallevels by about 2013. But sizable scalchallenges will remain in the areas o in-

rastructure, education and health as statestruggle to catch up in the a termath o threcession and slow recovery. Across thenation, including Texas, those issues canbe addressed when economic headwindsdiminish.

Saving is a senior research economist in the Re- search Department o the Federal Reserve Bank o Dallas.

Notes1This article will look primarily at state expenditures. Foin ormation on the revenue side o the equation, see “PFinances Deepen Recessionary Hole,” Federal Reserve BDallasSouthwest Economy,Fourth Quarter 2010.2 When matching previous spending levels, unadjusted infation and population growth, the gure is $15 billion.Addressing these actors and compensating or certain pspending cuts raises the gure to roughly $27 billion.

Chart 6Texas Pension Funding Exceeds Recommended 80 Percent in 2009

Less than 80

At least 80 in 2008, less than 80 in 2009

At least 80

Percent of pension system funded

SOURCE: Pew Center on the States.



OnTheRecord

SouthwestEconomy FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 20118

Dodd–Frank: Toward Greater Financial SysteA C o n v e r s a t i o n w i t hR o b e r t D . H a n k i n s

Robert D. (Bob) Hankins is an executive vice president at the Federal Reserve Bank o

Dallas, responsible or the Eleventh District’s banking supervisory activities. In July 2010,Congress approved the Dodd–Frank Wall Street Re orm and Consumer Protection Act inresponse to the global fnancial crisis. At almost 2,000 pages, the act spells out new lawsand regulations whose ramifcations or fnancial institutions are broad and complex. Inthis interview, Hankins felds questions about the act and its implications.

Q.What are the major goals o the fnancialre orms as laid out in the Dodd–Frank Act?

A. The best summary o Dodd–Frank’s goals

is ound in its preamble, which states that theact aims to promote nancial stability, end“too big to ail” ( ailing banks allowed to con-tinue operating because they are consideredtoo large to be closed), protect taxpayers by ending bailouts and protect consumers romabusive lending practices. O course, whetherit accomplishes these objectives has been thesubject o a considerable debate.

Q.Dallas Fed President Richard Fisher hasspoken at length about the dangers o fnancialinstitutions that are too big to ail. How does

Dodd–Frank address this? Are the changes likelyto be e ective?

A. Protecting the nancial system and taxpay-ers rom the consequences o di culties atlarge nancial institutions was one o Dodd–Frank’s main goals. The legislation containsa number o sa eguards and changes to thesupervisory apparatus intended to accomplishthis. For instance, large, systemically importantinstitutions—and not just banks, by the way—

will be subjected to enhanced prudential su-pervision, which is to be more stringent andrigorous than what we do or smaller institu-tions.

The banking supervision unction is alsoundergoing some undamental changes. Inaddition to ocusing on individual institutions,

we are also taking a more macroprudentialperspective that looks at threats to the stability o the entire nancial system. Finally, Dodd–Frank implements a new resolution regimethat allows ailing nancial rms such as largebank holding companies or other important

nancial rms to enter into receivership to a-

cilitate an orderly wind down o operations.This option wasn’t available during the crisisand should help deal with too big to ail.

Q.You said even nonbank frms that aredesignated as systemically important will nowbe subjected to enhanced supervision. How willthis designation be made? Have any nonbankfrms been identifed yet?

A. The Financial Stability Oversight Council,composed o all major nancial market regula-tors, will determine which nonbank rms aresystemically important. Dodd–Frank lists 10criteria that the council must consider. Theseinclude things such as size, leverage, inter-connectedness and importance as a source o credit. The council issued an Advanced Noticeo Proposed Rulemaking in October 2010 thatsought input on developing a ramework ormaking its designations. A ter getting publiccomment, the council issued a ormal request

or comment on its proposal o how to selectnonbank rms or enhanced supervision. But,refecting the importance and signi cance the

council places on these decisions, it recentlindicated that it will seek additional commenSo, no rms have yet been named. Any dtermination requires a two-thirds vote by thcouncil, including the chairman’s approvEven a ter that, a company has the right tohearing be ore the council, which is requirto submit a report to Congress regarding thdecision. The determination is also subject judicial review.

Q.How are institutions going to be supeWhat changes, in particular, are in store Dallas Fed?

A.The Federal Reserve is now responsible supervising all organizations that are deemesystemically important. This will include baholding companies with $50 billion or more assets and the nonbank nancial rms that thFinancial Stability Oversight Council deciare important to nancial stability. The Fed walso be responsible or developing enhanceprudential standards or these institutionThe goal is to subject these systemically important nancial institutions, or SIFIs, as thhave come to be known, to greater oversigh

and more rigorous standards that refect theheightened risks they may pose. Things sucas capital requirements, liquidity requiremenand overall risk-management strategies are ging to be more stringent or the SIFIs.

As ar as the Dallas Fed is concerned, whave one institution that meets the act’s minimum-size requirement or enhanced supersion, Dallas-based Comerica Inc. Dodd–Fraalso places the supervision o savings-and-loholding companies under the Fed, since thact does away with the O ce o Thri t Su

vision. For us, that means supervision o abo25 extra organizations, one o which, San Atonio’s USAA, is the largest nancial institubased in Texas.

Q.During the crisis, the Federal Reserveintroduced a number o emergency meato help stabilize fnancial markets. Does Frank a ect the Fed’s ability to respon

uture crises?

A. In response to events that un olded at aincredibly rapid pace during the crisis, the Fe



“Until someone invents a crystal ball that works, the best we can

do is try to minimize the impact o the next crisis through e ective,

though not stifing, supervision and preservation o capital.”

mostly invoked Section 13(3) o the FederalReserve Act, which allowed it to lend to any entity under “unusual and exigent circum-stances” as long as ve members o the Boardo Governors approved. Dodd–Frank requiresthat any such aid program or acility be broad-based and not directed at any one institution.

Also, while the Fed consulted with the Trea-sury be ore setting up the various programs,it wasn’t required to do so. Now, the legisla-tion requires that the Fed gain the Treasury’sapproval be ore establishing any similar pro-grams or acilities.

Q.Since Dodd–Frank imposes additionalregulation and ees on the banking industry, willthese greater costs a ect banks’ ability to lend?Is there a di erence between small and largebanks?

A. Studies have shown that the cost and bur-den o regulation all disproportionately onsmaller banks. Larger banks can more eas-ily absorb the increased expense, and that is

why it is important that as much as possiblebe done to minimize the impact on smallerbanks. And, o course, the potential impact on

lending or banks o all sizes increases with ris-ing cost structure and sta time devoted to en-suring compliance with laws and regulations.

At the same time, we have seen the result o reckless lending practices and disregard orprudent risk management on credit availability as banks work to repair balance sheets andrebuild capital. So, I guess the real questionis whether the cost o prevention—the intento Dodd–Frank—is cheaper than the cure?I would argue or the ormer, but I certainly understand the rustration elt by those whoplayed by the rules and who must now bearsome o the burden or those who did not.

Q.What are you hearing rom the Dallas Fed’sdistrict banks? What are the biggest changesthey will con ront?

A. As I participate on regulatory panels and with President Fisher in CEO orums aroundthe district, the common theme is concernabout the increased regulatory burden and as-sociated cost. The Dallas district consists large-ly o community banks. While Dodd–Frank

was aimed primarily at enhanc-ing the supervision o the larg-est organizations that create thebiggest risk to nancial stability,community bankers are con-cerned about the trickle-downe ect. They are anxious thatDodd–Frank regulations andpolicies adopted by the super-

visory agencies will be writtenand applied as one-size- ts-all.The bankers I talk to are wor-ried about how they will absorb increasedcompliance costs and remain pro table and

viable, meeting the credit needs o their com-munities.To allay these concerns, the Federal Re-

serve is trying to provide more guidance tobankers and examiners about what applies tocommunity banks and what doesn’t. Addition-ally, the Federal Reserve’s Supervision Com-mittee has established a subcommittee to ocuson the e ects o proposed rules on community banks. Each Federal Reserve district has alsocreated a Community Bank Depository Institu-tion Advisory Council. A representative romeach o the councils meets twice a year with

the Board o Governors to provide direct eed-back on issues a ecting community banks.

Q.I the supervisory structure and regulationsin Dodd–Frank had been in e ect during therecent housing boom and bust, do you think thefnancial market crisis that ensued would havebeen more limited in depth and breadth? Pleaseexplain.

A.You would certainly like to think so, but you will never know. The real question, I think, is whether Dodd–Frank will prevent another cri-sis. My response is, probably not. Respondingto the savings-and-loan and banking crises o the 1980s and early ’90s, Congress passed theFinancial Institutions Re orm, Recovery andEn orcement Act o 1989 and the Federal De-posit Insurance Corporation Improvement Acto 1991 with the idea they would prevent a

uture crisis. Obviously, they did not. To quotemy good riend Thomas Hoenig, who untilOct. 1 was president o the Kansas City Fed,“I have a crystal ball on my desk. It doesn’t

work.”

Until someone invents a crystal ball th works, the best we can do is try to minimiz

the impact o the next crisis through e ecthough not stifing, supervision and preservation o capital. Lessons have been learned a

will be applied going orward. But by thnature, laws and regulations are backwardlooking, designed to prevent the cause o thlast crisis rom being the cause o the next o

Q.So, what is your overall assessment oDodd–Frank?

A. Legislation this sweeping and comprehesive is bound to be controversial, and Dodd

Frank is no exception. We’ve certainly heamany doubts about whether it really ends taxpayer bailouts and too big to ail, and we’heard a number o complaints about increasregulatory burden. There is also concern abothe inevitable unintended consequenceThese are all valid. But instituting a more maroprudential approach to the supervisory process, along with a new resolution regime

ailing rms, and extending regulatory ovsight to important players within the nancisystem that aren’t banks are important stepthat hope ully will result in a sa er and msound nancial system.


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Private Equity IndustrySouthwest Firms DrawRegional Expertise By Alex Musatov and Kenneth J. Robinson

The private equity industry

runs the gamut rom small

venture-capital investments

in startup companies

to multibillion-dollar

buyouts o well-known

public corporations.

N eiman Marcus, Harrah’s, Petco, J.Crew—these well-known names are amongthe holdings o companies owned or co-owned by private equity (PE) rms in theFederal Reserve’s Eleventh District. Theregion is home to more than 175 PE rms,including the world’s third-largest, Fort

Worth-based TPG Capital.1 Together, theseentities have raised more than $109 billionover the past 10 years and sit on $31 billionpending investment.2

While the PE business model goesback to the times o early sea aring enter-prises unded by limited private partners,its modern U.S. iteration dates back to the1950s and the rst venture capital unds.More recently, the industry and its some-times opaque operations have come under

increased regulatory scrutiny amid concernabout their riskiness and systemic impor-tance to the nancial system. Although de-tailed data are hard to come by, regionally based PE rms are distinguished rom theircounterparts nationwide by the sectors they

avor.

What ‘Private Equity’ MeansThe term “private equity” is used very

broadly—o ten inconsistently—because itencompasses a vast range o strategies orinvesting in companies whose shares are

not publicly traded. In its simplest orm, aPE rm consists o a team o pro essionalinvestors who declare their intent to raisea und o speci ed size with an expressedinvestment strategy. The team solicits ac-credited investors—primarily institutionalmoney managers and high-net-worth indi-

viduals—to raise the targeted amount.Once a und is closed to additional in-

vestors, the rm deploys its capital througha series o acquisitions, generally occurringover a period o up to three years. The next

ve years or so are spent managing, advis-ing and improving the port olio o companies.

The nal stage o the private equity cycle—the exit stage—entails divestiture,

with the acquired rms typically operationally stronger and more valuable, refectingthe PE sector’s bene ts to the economy.Exits can take the orm o an initial publio ering o shares or a sale to a corporatebuyer or another PE rm. The ull cycleo ten requires a 10- to 15-year commitme

rom investors, highlighting the long-termgenerally illiquid characteristics o privateequity nancing.

Nonpublic FundingThe PE industry runs the gamut rom

small venture-capital investments in startucompanies to multibillion-dollar buyouts o well-known public corporations. They allshare a nonpublic unding structure underthe leadership o a pro essional generalpartner who deploys capital raised romlimited partners. The PE universe is mosto ten segmented by the li e-cycle stage otarget companies— rom startups to maturoperations.

“Venture capital” rms invest almostexclusively in young companies, o ten be

ore their rst revenues materialize. Ventucapitalists are o ten willing to lose their entire principal on most investments in orderto hit a home run with one potentially revolutionary technology or business methodthat reaps enormous returns. The earlierthe stage targeted, the higher the risks andthe greater the potential rewards. In addi-tion to capital, venture capital entities o teprovide technical know-how and industry expertise to their port olio rms. Google,Microso t and Apple are some o the mosillustrious venture capital success stories.



“Growth equity” and “mezzanine debt”unds target companies in later stages

than venture capital. These PE participantsprovide capital—either equity or debt—to

young but stable businesses that requirebridge nancing between venture capi-tal and public nancing.3 PE rms in thisparticular segment hope to capitalize onrapid growth and typically exit the invest-ment once the rm can access bank loansor public equity markets. Mezzanine debtre ers to cases when a PE und opts to lendto, rather than provide equity in, a growing

rm. The loans typically have very fexibleterms but rank below senior debt in theevent the company de aults. For this addedrisk, mezzanine unding comes with rela-tively high interest rates.

The “leveraged buyout,” or LBO, is by ar the largest and most recognized private

equity strategy. Many think o PE and LBOas synonymous. LBOs are o ten involved inthe acquisition o amous brands, combin-ing equity with large amounts o borrowingto employ signi cant leverage and gaincontrol o target companies.

Debt is a key component o this busi-ness model because the leverage employedcan ampli y the returns generated by aninitial equity investment. Buyout rms targetcompanies that have strong, predictablecash fows since those will be needed to re-pay large borrowings. This makes the buy-out segment highly dependent on the debt

markets or nancing. The banking industry plays a key role in LBOs. As o June 30,U.S. banks reported $115.4 billion in lever-aged loans and securities on their books.

In addition to these primary styles,PE rms pursue various specialized invest-ment strategies. This “other” group includes

rms that invest exclusively in nancially distressed businesses and companies on thebrink o bankruptcy (or already in bankrupt-cy proceedings) and PE rms that invest inother PE rms, so-called secondaries.

Funds committed to LBOs account orthe largest relative amount o PE capitalavailable or investment in each o the ma-jor strategies (Chart 1 ).

Within each segment, PE rms special-ize primarily by industry and size o target

rm. With the exception o the largest PErms, which tend to diversi y across indus-

tries, und managers pre er to acquire rms within very speci c subsegments, o ten le- veraging one port olio rm to help anotherone grow or even merging related businessinto a single entity. Narrow industry special-ization has been shown to produce higherreturns, and industry participants—includ-ing potential acquisition targets—pre er PE

rms with deep experience in a particularsector.4

Surviving the Financial CrisisThe PE industry has largely recovered

rom the recent global economic turmoil,

Chart 1Leveraged Buyouts Are Largest Share o Private Equity Available CapitalPercent o PE available capital

0

10

20

30

40

50

60

70

80

90

100

OtherLeveraged buyoutsGrowth equity and mezzanine debtVenture capital

201120102009200820072006200520042003

NOTES: “Available capital” re ers to capital not yet invested at year-end. 2011 data are through second quarter.

SOURCE: Preqin.

Narrow industry specialization

has been shown to produce

higher returns, and

industry participants—

including potential acquisition

targets—pre er private equity

rms with deep experience

in a particular sector.



refecting the long-term nature o its model, with investors committing unds or 10 to15 years and anticipating a lack o interimliquidity. The industry, there ore, tends toexperience less instability than equity and

xed-income markets.5 Still, with the onseto the nancial crisis, PE capital declinedsteadily as the infow o new investment

unding slowed; capital peaked at almost$900 billion globally in 2008.6

The industry has also been placed underincreased regulatory scrutiny. The Dodd–Frank Wall Street Re orm and ConsumerProtection Act, signed into law in July 2010,requires that PE and hedge unds as well asother private pools o capital with at least$150 million in assets under managementregister with the Securities and ExchangeCommission.7 The law also imposes newrecord-keeping and disclosure requirementsthat will give nancial supervisors in ormationto evaluate both individual rms and the stateo the overall market, closing a regulatory gapthat had existed in this sector o the nancialmarketplace.8

The economic downturn and heightenedinvestor risk aversion a ected the industry’sdynamics. A large portion o the capital at-tracted during the 2005–08 peak years re-mains dormant because o limited pro tableinvestment opportunities. Although investorscurbed some incremental commitments, andtotal unds raised contracted a ter 2008, PE

rms couldn’t spend the large cash positions

they had already built up (Chart 2 ).In response, some PE rms diversi ed

outside o their standard business models,pursuing alternative investment strategiesthat include hedge unds and real estate

unds. In addition, the relative health o corporate balance sheets has increasedcompetition or purchase targets. Corpora-tions now periodically outbid PE rms inauctions or business acquisitions.9

Southwest Private Equity While PE is global in most respects—

U.S. investment interests can raise money rom a European pension und and invest

it in Asia—individual rms tend to clusternear hubs o their target industries. Proximity allows und managers to build industryrelationships, identi y potential targets andmanage a company more actively a ter itsacquisition. Also, PE rms pre er to hireinsider experts directly rom their target industries—and expert sta is o ten reluctto relocate.

Proximity can be especially importantor venture capital rms, which must o ten

identi y promising investments even be orea ormal company exists. Out o 29 PE rmin Austin, or example, 19 ocus on high-te

venture capital. Largely due to the presenceo prominent high-tech companies such asDell and a large university population, Austiis home to almost one-third o all venturecapital rms in Texas.

Chart 2Ready Capital in U.S. Remains High Despite Decreased FundraisBillions o dollars

0

100

200

300

400

500

600

700

New funds raised

Available capital

201120102009200820072006200520042003

NOTES: “Available capital” re ers to capital not yet invested at year-end. 2011 data are through second quarter.

SOURCE: Preqin.

A large portion o the capital

attracted during the 2005–08

peak years remains dormant

because o limited pro table

investment opportunities.



This locational aspect o the PE in-dustry suggests that PE rms based in theSouthwest (de ned as Texas, Louisiana,New Mexico and Oklahoma) might di -

er somewhat in their ocus. PE rms bothnationally and in the region invest across a

wide number o industries (Chart 3 ). Notsurprisingly, Southwest-based PE entitiesparticipate more in energy industry transac-tions, given the region’s traditional ocus onoil and gas.

O all PE transactions by regional rmssince 2005, 11 percent targeted the oil andgas sector, almost triple the national rateo 4 percent.10 In contrast, Southwest PE

rms are somewhat less concentrated in thetechnology and communication sector (10percent versus 14 percent nationally) andin business services and media (12 percent

versus 16 percent nationally). Southwest PErms tend to invest in other industry groups

in airly similar proportions to nationaltrends.

Regional AdvantagePE is an important source o capital or

emerging companies and mature corpora-tions. Firms in the our-state Southwest regionhold $31 billion in ready-to-invest capital, asigni cant amount in the context o the $51billion in business loans on the books atbanks in the Federal Reserve’s slightly smallerEleventh District.

Like much o the nancial services in-dustry, PE is in a period o transition borneo economic turmoil and regulatory change.

Some rms have moved outside their tradi-tional boundaries. Yet the increasingly globalindustry retains its regional favor, refectinga desire to capitalize on the advantages andspecialized knowledge o industries at home.

Musatov is an alternative investments specialist and Robinson is a research o fcer in the Finan-cial Industry Studies Department at the Federal

Reserve Bank o Dallas.

Notes1 As measured by total unds raised in the past 10 years. TheEleventh District encompasses Texas and parts o Louisiana andNew Mexico.2 This compares with the U.S. total o $1.65 trillion raised overthe past 10 years and $455 billion awaiting investment, known inthe trade as “dry powder.”3 Growth equity and mezzanine debt are both very fexible, diversestrategies and may pursue rms at any stage. For simplicity, we

ocus on their pre erence or mid-cycle companies.4 See “Playing to Their Strengths? Evidence that Specializationin the Private Equity Industry Con ers Competitive Advantage,”by Robert Cressy, Federico Munari and Alessandro Malipiero,Journal of Corporate Finance,vol. 13, no. 4, 2007, pp. 647–69.5 Changes in asset values are not directly observable becausethere is no public market or rms owned by PE investors.6 All data on the PE industry are rom Preqin.7 Venture capital unds are exempt rom registration requirements.8 See U.S. Senate Report 111-176, 111th Congress, 2d Session,April 30, 2010, pp. 71–72.9 See “Corporates Outbid Private Equity or Good Assets,” byMarietta Cauchi, Marketwatch.com, June 24, 2011.10 The data in Chart 3 are based on number o transactions. Dataon the dollar amount o investments by industry are available orroughly 30 percent o transactions.

Chart 3Private Equity Transactions Di er in Southwest Region(January 2005 to July 2011)

U.S. Southwest

Transportation, shipping,logistics, utilities & distribution

Technology & communication

Health care, medical,pharmaceuticals, life sciences

Hardware, industrial,manufacturing & infrastructure

Financial services

Energy, oil & gas

Consumer products & services

Business services & media

14%

7% 16%

17%

4%

8%25%

11%

10%

9%12%

15%

11%

8%25%

10%

NOTE: Percentages may not add to 100 due to rounding.

SOURCE: Prequin.

Not surprisingly, Southwest-

based private equity entities

participate more in energy

industry transactions, given

the region’s traditional ocuson oil and gas.


http://slidepdf.com/reader/full/southwest-economy-4q-2011 14/16SouthwestEconomy FEDERAL RESERVE BANK OF DALLAS • FOURTH QUARTER 201114

NoteWorth yQUOTABLE:“Texas’ exports face headwinds from two sources: ain Mexico and emerging Asia—particularly China—and a strong

—Anil Kumar, Senior Resear

DEFENSE SPENDING:Economic Beneft Likely to Diminish in Tex

RECORD DROUGHT:Agriculture Losses Estimated at $5.2 Billion

National de ense strongly infuences the Texas economy through 20 area military installations and the companies pro-

viding them with goods and services. Additional bene ts ariserom spending by military personnel and by the De ense De-

partment on aircra t and equipment produced by area manu-acturers such as Lockheed Martin and Bell Helicopter.

All told, de ense purchases and pay or military and civil-ian personnel in Texas amounted to $65.6 billion in 2009, orabout 9.7 percent o U.S. de ense spending. A ter accounting

or spillover e ects in the local economy rom inputs used by de ense contractors and goods purchased by military person-nel, total spending in Texas was estimated at $108.6 billion.

Compared with other large states, Texas ranked second

behind Cali ornia in terms o spending. However, on a pcapita basis, Texas was ninth at just under $3,500.

The Base Realignment and Closure program institutein 2005 and ongoing conficts in Iraq and A ghanistan led a military infux that had boosted Texas in rastructure invement, particularly bene ting Fort Bliss in El Paso and FoSam Houston in San Antonio.

However, the outlook is less rosy. Military spending Texas will likely all amid overall de ense reductions begning in 2012 as part o de cit-cutting measures by CongreSpending in Texas will decline to $51.7 billion by 2015, a 2percent drop rom 2009, De ense Department estimates sho

—Jackson Thie

Texas’ agricultural sector is tallying up record lossesdue to an unprecedented drought. The 12 months endedin September were the driest since recordkeeping beganin 1895. The U.S. Drought Monitor ound 92 percent o thestate in extreme or exceptional drought as o mid-October.

Crop and livestock losses are estimated at $5.2 billion,or 25 percent o usual agricultural production value, ac-

cording to the Texas AgriLi e Extension Service at Texas A&M University. The total surpasses the previous record orcostliest drought o $4.1 billion in 2006.

Low yields and crop abandonment at a time o highcommodity prices produced losses o $1.8 billion in cotton,$750 million in hay, $327 million in corn, $243 million in

wheat and $63 million in sorghum production. Crop insuance lessened the impact o income losses or many arm

The cost to the livestock sector was $2.1 billion, wi82 percent o pastures and rangeland in very poor condtion and hay prices increasing two old to three old rom

year ago. Ranchers culled herds due to water and eed conditions, depressing market prices in the short term. How

ever, prices remain relatively high, mitigating the e ectIn addition, the drought lowered income or agricu

ture workers and sales o arm services and supplies suas gins, elevators and ertilizer. AgriLi e Extension estimthe sum o direct and indirect losses at $8.7 billion this ye

—Yingda B

PERSONAL INCOME:Further Declines Seen in Texas and U.S.Many economic indicators in Texas and the U.S. con-

tinued to decline in 2010 even though the recession endedin 2009. While Texas still lags behind in certain key mea-sures o citizens’ well-being, some o the gaps appear to benarrowing.

Texas’ real median household income ell 1.6 percentto $47,464 in 2010, compared with a U.S. reduction o 2.3percent, or more than $1,100, to $49,445, according to the2011 Current Population Survey Annual Social and Eco-nomic Supplement.

Texas’ lesser decline allowed it to move closer to the

national income level than it has been since 2001.The share o Texas residents without health insurance

decreased 1.5 percentage points during 2010 to 24.6 pecent. The U.S. recorded a 0.4 percentage-point drop t16.3 percent. While Texas experienced the ourth-largedecline in such coverage gaps in the U.S., the state continues to have the largest percentage o people withouhealth insurance—3 percentage points greater than in NewMexico, the next-highest state.

The Texas poverty rate increased to 18.4 percent i2010, a year-over-year increase o 1.1 percentage poinThe national poverty rate rose to 15.1 percent, up 0.8 percentage points. The national and state rates climbed ttheir highest levels since the early 1990s.

—Christina Dal



SpotLi g ht

F ED ER AL R ES ERVE B AN K OF D AL LA S • FO UR TH Q UA RT ER 2 01 1Southwest Economy15

Gains Aren’t Simply a Low-Wage Jobs STexas Employment

A mid reports o the nation’s weak eco-nomic recovery, high unemployment andslow job growth, attention has turned to Tex-as, the only large state on track to surpass itsprerecession peak employment by year-end.Since the U.S. recession concluded in 2009,Texas employment has grown 3.3 percent,compared with 0.6 percent or the rest o thestates.1 Texas added 827,000 jobs, an 8.7 per-cent increase, between 2001 and 2010 and ex-panded in every category except manu actur-ing, in ormation and construction. The nationlost 2.8 million jobs during that period, a 2.3percent decline.

Texas has bene ted rom a range o actors, notably high commodity prices, par-ticularly oil, and development o new drillingtechnologies. Rapidly growing exports, highpopulation growth and robust in-migration o people and businesses also contributed. Rela-tively healthy banks and the lack o a housingbubble cushioned the blow o the recession.

State job gains, which have bene tedrom strong undamentals, have been relatively

rapid and broad based. Even so, the wage pic-ture is mixed.

O the 22 major occupational categoriessurveyed by the Bureau o Labor Statistics, em-ployment rose in 18 o them in Texas versus 11in the rest o the states between 2001 and 2010(Chart 1 ).2 Texas jobs grew astest in commu-nity and social service, which has a medianhourly wage o $19, higher than the $16 me-dian or all U.S. jobs in 2010. Other rapidly growing categories include health care sup-port, with a median wage o $10; personal careand service, with a $9 median, and businessand nancial operations, with a $29 median.

While more lower-wage jobs were cre-ated, higher-paying positions grew at a asterrate in the state, making up an increasing pro-portion o total jobs. Texas jobs in occupation-al categories with wages above the U.S. me-dian increased 11.9 percent rom 2001 to 2010,

while jobs with wages below the U.S. medianrose 7.9 percent. That translates to 391,000higher-wage jobs and 470,000 lower-wageones. Positions in occupational categories pay-ing more than the U.S. median accounted or36.4 percent o total Texas jobs in 2010, up

rom 35.5 percent in 2001.Despite the expanding share o high-wage

Chart 1

Texas Sees Job Growth in High- and Low-Wage Occupations

U.S.

Texas

Percent change–50 –40 –30 –20 –10 0 10 20 30 40 50

Farming, shing and forestryManagementProductionLife, physical and social scienceInstallation, maintenance and repairConstruction and extractionArchitecture and engineering

Building and grounds cleaning and maintenanceTransportation and material movingOfce and administrative support

AllSales and related

LegalProtective service

Food preparation and serving relatedComputer and mathematical

Education, training and libraryArts, design, entertainment, sports and media

Health care practitioners and technicalBusiness and nancial operations

Personal care and serviceHealth care support

Community and social service 1910

929

2719

23358

1733

1115

1413

9

3415

1826

1442

10

NOTES: Percent change rom 2001 to 2010. Figures beside category labels are Texas median hourly wages, in dollars.

SOURCE: Occupational Employment Statistics, Bureau o Labor Statistics.

jobs, Texas pay started and nished the decadeat about 93 percent o U.S. levels (Chart 2 ).3 Clearly, state wages fuctuated with the busi-ness cycle, alling during the jobless recovery o 2003–04 and rising in 2009–10. While real(infation adjusted) wages in Texas increased

rom $14.87 in 2001 to $15.14 in 2010, they re-main below U.S. levels. The di erence refectsa lower cost o living. However, Texas workersare also younger and less educated, on aver-age, and more likely to be oreign born.

While Texas wages trail those o the U.S.,job creation does not appear to be dispropor-tionately low-wage. State trends over time re-semble those o the U.S., with lower wage lev-els best explained by demographic di erences.

—Pia Orrenius and Yingda Bi

Notes1 Texas employment uses Federal Reserve Bank o Dallasemployment data, while employment or the rest o the statesis calculated using U.S. National Survey data minus Texasemployment. Using Bureau o Labor Statistics data or Texas andthe sum o states, Texas employment has grown 3.2 percent,compared with 0.7 percent or the rest o the states.2 Occupational Employment Statistics rom the Bureau o Labor

Statistics provide annual data on employment and wagesdetailed occupation at the state and national levels. Wageare expressed in 2010 dollars and exclude the value o bene ts. Wages have been defated using CPI-U, the ConPrice Index or All Urban Consumers, in Chart 2.3 In 2010, the Texas median hourly wage was $15.14; themedian was $16.27.

Chart 2Texas Wages Lag Behind U.S.Median hourly wage (real dollars) Percent

12

13

14

15

16

17

‘10‘09’08‘07’06‘05’04’03’02’0190

91

92

93

94U.S. Texas share of U.S.

SOURCE: Occupational Employment Statistics, Bureau o LaboStatistics.



PRSRT STDU.S. POSTAGE

PAID DALLAS, TEXAS

PERMIT NO. 151

Federal Reserve Bank of DallasP.O. Box 655906Dallas, TX 75265-5906

SouthwestEconomis puquarterly by the Federal Reserve Bank o Dalexpressed are those o the authors and shoultributed to the Federal Reserve Bank o DallasReserve System.

Articles may be reprinted on the condisource is credited and a copy is provided to tDepartment o the Federal Reserve Bank o D Southwest Economy is available ree owriting the Public A airs Department, FederalDallas, P.O. Box 655906, Dallas, TX 75265-5906922-5268; or by telephone at 214-922-5254. Thiis available on the Dallas Fed website, www.dalla

Executive Vice President and Director o Harvey Rosenblum

Director o Research PublicationsMine Yücel

Executive EditorPia Orrenius

EditorMichael Weiss

Associate EditorsJenni er A ferbach

Kathy Thacker

Graphic DesignersSamantha Coplen

Ellah Piña

The Texas Service SectorOutlook SurveyNew rom the Federal Reserve Bank o Dallas:a monthly gauge o Texas service-sector activity,the largest part o the state economy. The TexasService Sector Outlook Survey (TSSOS) includes aspecial breakout or retail and wholesale busi-nesses, the Texas Retail Outlook Survey (TROS). The new measurements complement the long-standing Texas Manu acturing Outlook Survey,the Dallas Fed’s gauge o state actory activity.

Look or the Texas Service Sector Outlook Surveyand companion reports atwww.dallas ed.org/research/surveys

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