Full text of The Southwest Economy : Fourth Quarter 2011

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Fourth quarter 2011

SouthwestEconomy
FEDERAL RESERVE BANK OF DALLAS

In This Issue
On the Record:
Dodd–Frank: Toward
Greater Financial
System Stability
Private Equity
Industry: Southwest
Firms Draw on
Regional Expertise
Spotlight: Texas
Employment Gains Aren’t
Simply a Low-Wage Jobs
Story

States Still Feel Recession’s
Effects Two Years
After Downturn’s End

President’sPerspective
TConsumer
he Dodd–Frank Wall Street Reform and
Protection Act­—one of the most sig-

If we have not eradicated
too big to fail from our
financial infrastructure
with the myriad rules and
regulations we are writing
and implementing,
financial reform and
stability will have eluded
us yet again.

nificant responses to the financial crisis—was
signed into law a little more than a year ago.
The act establishes a new regulatory infrastructure for promoting financial stability.
Dodd–Frank mostly provides high-level
direction, leaving critical decisionmaking and
a number of details to regulatory discretion.
Many of its most prominent features, including
the Financial Stability Oversight Council and
new Federal Reserve responsibilities overseeing some nonbank financial companies, are
explained in greater detail by Dallas Fed Executive Vice President Robert D. (Bob) Hankins
in the “On the Record” feature in this issue of
Southwest Economy.
A primary purpose of Dodd–Frank is ending “too big to fail.” During the recent financial crisis, when smaller banks got into deep
trouble, regulators generally took them over.
Failing big banks, however, were allowed to lumber on with government support, despite extensive fallout. Big banks that gambled and generated unsustainable
losses received a huge public benefit: too-big-to-fail support.
As a result, the most imprudent lenders and investors were protected from the
consequences of their decisions. This strikes me as counter to the very essence of
competition that is the hallmark of American capitalism. In crafting Dodd–Frank
mandates, we need to restore market discipline in banking and let the market
mete out its own brand of justice for excessive risk taking, rather than prolong the
injustice of too big to fail.
We still have work to do. The top 10 banking institutions now account for 65
percent of banking assets, substantially more than the 26 percent of 10 years ago.
When it comes to these largest institutions, we must apply Dodd–Frank extensively
and vigorously. If we have not eradicated too big to fail from our financial infrastructure with the myriad rules and regulations we are writing and implementing,
financial reform and stability will have eluded us yet again.
I trust regulators will rise to the challenges posed by the financial crisis and too
big to fail. By doing so, we will leave a legacy of success and functional infrastructure for next-generation supervision and regulation.

Richard W. Fisher
President and CEO
Federal Reserve Bank of Dallas

States Still Feel Recession’s Effects
Two Years After Downturn’s End
By Jason Saving

Tmarket-driven
he U.S. economy entered a financialrecession in December 2007

The nation ultimately is the
sum of its parts and cannot
fall into a serious recession
without it affecting most
states and their finances.

from which it has yet to fully recover. The
boom of the mid-2000s has been replaced
with a stubborn national reality of high unemployment and sluggish output growth,
with no clear indication when economic
activity will return to more normal levels.
Yet the states have, in many ways, borne
the brunt of the recession. Demand for public
services increased at the very moment tax
revenue—especially from property taxes—declined. As late as this October, a full two years
after the recession ended, states from Florida
to California to New York warned of new
shortfalls that must be addressed through
spending cuts and tax increases. In Texas,
lawmakers completed work on cuts totaling
at least $15 billion for the upcoming two-year
budget cycle.
As the nation’s economic woes continued, the federal budget deficit climbed, pos-

Chart 1
State Shortfalls Reach Record $174 Billion in 2010
Billions of dollars
200
180
Estimates

160

Projections

140
120
100
80
60
40
20
0

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

SOURCE: National Conference of State Legislatures.

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

3

ing potential limits on aid Washington could
provide. The deficit soared to $1.4 trillion in
2009 and is expected to remain above $1 trillion annually until 2013. At least one major
ratings agency downgraded the country’s
top-tier credit rating, warning as part of its
unprecedented action that officials must do
more over the short term to stabilize and improve the deficit picture. Other ratings firms
have similarly cautioned that their assessments of U.S. creditworthiness could be cut if
fiscal imbalances aren’t addressed.

How Have States Done?
Following the 2001 recession, state
budget outlooks improved. After posting
collective budget gaps of about $80 billion in 2003 and 2004, fiscal retrenchment
coupled with above-average economic
growth virtually eliminated shortfalls by
mid-decade. Even in the first full year of
the most recent recession, 2008, it appeared
states might weather the national economic
storm relatively unscathed.
Unfortunately, the nation ultimately is
the sum of its parts and cannot fall into a
serious recession without it affecting most
states and their finances. On the revenue
side, job losses and wage cuts reduced individual income and consumption, crimping
state revenue. And at the very moment revenue fell, residents beset by poor economic
conditions increased their demand for an
array of state-provided social services ranging from Medicaid to job training, driving
up expenditures beyond projections. The
result: a dramatic widening of state fiscal
gaps.
The depth of the recent recession
is vividly illustrated by ballooning state
deficits in 2009–11, which produced an
unprecedented three consecutive years of
more than $90 billion shortfalls (Chart 1).
In 2010 alone, 43 states confronted a cumulative $174.7 billion budget hole—the largest ever recorded. And while those deficits
narrowed somewhat in 2011, they are not

SouthwestEconomy

expected to return to prerecession levels for
at least two years amid the relatively weak
economic recovery.
With balanced budgets required in 49
of the 50 states by law or state constitution, jurisdictions coming up short must cut
services (or raise taxes) to bring spending
plans into balance. To be sure, budgetary
tricks—for example, strengthening nearterm economic assumptions or making
favorable assumptions about social-service
caseloads—can sometimes soften the blow.
These devices can only go so far, ensuring
that some sacrifices will be required.1
But were those measures limited to unnecessary and little-used programs, or did
states reduce funding to key budget areas,
such as health and education?
In 2010 (the last year for which data
are available), 43 states reduced funding for
higher education, according to the National
Association of State Budget Officers (Chart
2). This coincided with a period when outof-work individuals increasingly turned to
colleges for occupational retooling. Some
states also enacted policy changes to reduce support for higher education over the
longer term, continuing a trend seen over
the past few decades.
A slightly less common target was
K-12 education, which 34 states cut in
fiscal 2010 (October 2009 to September
2010). The reductions coincided with debate over whether class sizes had become
too large and student test scores too low.
Since a majority of most states’ outlays go
to education and health, substantial budget
cuts cannot—from a purely mathematical
perspective—occur without affecting either item. Typically, such reductions are at
least partially restored in later years as the
economy improves. The 2007–09 recession’s
aftereffects have lingered longer than many
expected, perhaps delaying by several years
the reinstatement of funding.
Public health programs were pared in
31 states; support for the elderly and disabled
was trimmed in 29. These cuts revealed a
paradox. States, while well-positioned to help
individuals when most citizens (and the tax
base) are healthy, struggle to offer their standard menu of benefits when widespread and
pervasive economic shocks increase the number of people needing assistance.
The difficulty could be mitigated by giving states more leeway to incur deficits. But,
as has become evident at the federal level,
deficit spending can create problems of its
own, at least over the medium to long term.

Chart 2
Most States Cut Health, Education, Other Areas in 2010
Number of states
50
45
40
35
30
25
20
15
10
5
0

Public health

Elderly/disabled

K-12 education

Higher education

Govt. workforce

SOURCE: National Association of State Budget Officers.

Chart 3
Texas Exceeds Nation in Job Growth
Quarter/quarter percent change*
6

4

2

0

–2

Texas

–4

U.S.

–6

–8
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

* Seasonally adjusted annualized rate.
SOURCES: Bureau of Labor Statistics; Texas Workforce Commission; Federal Reserve Bank of Dallas.

What About Texas?
As a majority of state economies entered recession in late 2007, Texas continued growing (Chart 3). And as most state
economies emerged from recession in
2009–11, Texas outperformed the remainder of the country in employment growth
by a full percentage point—about equal to
Texas’ historical advantage over the past
few decades.

SouthwestEconomy 4

Texas’ favorable performance stems
from a number of factors, including its oil
and gas industry, a low cost of living, favorable demography, restrictive home-lending
laws, an attractive business climate and a
housing sector that held up better than it
did elsewhere. These items do not and cannot guarantee growth here will exceed that
of the nation—Texas trailed the U.S. in 10
of the 86 quarters depicted in Chart 3, for

FEDERAL RESERVE BANK OF DALL AS • FOURTH QUARTER 2011

How Dependent Is Texas on Federal Funding?
Texas has significantly trailed the national average in federal spending per capita since the late 1980s
and has been somewhat below the national average in federal spending per tax dollar paid to Washington.
This means the Texas economy isn’t as dependent on federal spending as the typical state and receives less
for its contributions.
In 2005—the latest year for which complete data are available—Texas received roughly $6,500 per
person in federal outlays, compared with a national average of $7,600. The Texas figure is 86 percent of the
national average and places the state 42nd out of 50 in per capita federal funding.
Another way to address the conceptual question of Texas’ dependency on federal funding is to examine federal aid to state governments themselves, a narrower but somewhat less volatile measure of federal

As most state economies

support for a region. Here the answer is similar: Texas received $1,179 per person, compared with the
national average of $1,460, putting it in 43rd place.

emerged from recession in

This makes Texas somewhat of an outlier in its “neighborhood.” New Mexico routinely receives larger

2009–11, Texas outperformed

per capita federal outlays than any other state, for example—about 50 percent more than Texas. Louisiana is
also somewhat above the national average, receiving about 15 percent more than its much larger neighbor.

the remainder of the country in

What about stimulus funding? Might it be that Texas has received an influx of funding whose sudden
withdrawal would cause hardship relative to other states?

employment growth by a full

It turns out that official government data on stimulus funding by states are broadly consistent with

percentage point—about equal

other outlay data. To date, Texas has been awarded $674 per person in stimulus-related contracts, grants
and loans from the federal government. While this puts Texas in second place among the states in total

to Texas’ historical advantage

dollars received, Texas ranks 48th on a per capita basis, behind only Florida (whose governance resembles
Texas’ in many respects) and New Jersey. The bottom line: Texas is not disproportionately dependent on

over the past few decades.

stimulus monies.
One final issue concerns the possibility of a downgrade to Texas’ credit rating if the nation’s creditworthiness were reduced. Texas is currently one of 15 states to boast a top-tier rating from Moody’s, for
example. Five of those 15 were recently placed on a downgrade watch and would face a likely cut if there
were a technical default by the U.S. But Texas was not one of the five, in part because it is less dependent on
federal funding. So while the possibility of a state downgrade cannot be ruled out, there are few indications
it will happen in the near term.

example. But they do suggest that, other
things being equal, Texas economic activity
should be at least slightly stronger than the
national average.
Despite this relatively favorable environment, Texas entered the 2012–13 budgeting biennium with a shortfall of between
$15 billion and $27 billion, depending on
the spending baseline chosen.2 This gap
represents about 10 percent of state spending and 1 percent of economic activity over
the two-year cycle. In light of the $3 billion to $4 billion in debt accumulated by
the federal government daily, roughly $20
billion over two years may not seem especially significant. But it is a large amount
in a state that offers little assistance to the
poor and prides itself on a business-friendly
(read: small and efficient) tax and regulatory regime. (See accompanying box.)
The Legislature passed and the governor signed a $172.3 billion budget for
fiscal 2012–13—about $10 billion below

the previous two-year budget and $15 billion less than actual 2010–11 expenditures.
Each spending category depicted in Chart
2 was cut, with an especially large proportion borne by health services. A variety of
elements prevented even larger reductions.
These included increased revenue from a
recovering state economy, a larger-than-expected withdrawal from the state’s rainy-day
fund and just under $5 billion in “nontax
revenue enhancements” such as higher license and registration fees.

Downgrading Debt?
As if state budget cuts were not
enough, questions about excessive state
government indebtedness have arisen. Following S&P’s downgrade of U.S. borrowings, ratings firms said debt-ridden states
might themselves be lowered in the near
future—as Nevada and New Jersey were
earlier this year and California was in 2010.
Texas, however, has not been cited as a

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

5

SouthwestEconomy

Chart 4
Texas Trails Rest of Nation in State Per Capita Debt
Thousands of dollars
4

Rest of U.S.

3

2

Texas has historically enabled
localities—cities, counties and

Texas
1

school districts—to undertake
functions that elsewhere might
be done (or at least paid for)

0
1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

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

by the state.
Chart 5
Texas Mirrors Rest of Nation in State and Local Per Capita Debt
Thousands of dollars
10
9
8
7
6
Rest of U.S.

5

Texas

4
3
2
1
0
1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

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

downgrade candidate. How do its debt levels compare with those in other parts of the
country?
Such a comparison would generally
use per capita state debt. Over the past two
decades, per capita state debt shows Texas
at about one-third the debt level of the rest
of the nation (Chart 4). In 1993, for example, Texas incurred per capita state debt of
$478 versus $1,576 for the remainder of the
nation. In 2009, the last year for which data

SouthwestEconomy 6

are available, the comparison was $1,228
versus $3,599.
However, Texas has historically enabled localities—cities, counties and school
districts—to undertake functions that elsewhere might be done (or at least paid for)
by the state. This suggests that a more valid
comparison would need to include local as
well as state debt.
In terms of state and local per capita
debt, Texas essentially tracked the rest of

FEDERAL RESERVE BANK OF DALL AS • FOURTH QUARTER 2011

$15 billion to $27 billion shortfall almost
exclusively through expenditure reductions.
Across the country, state debt issuance has risen in recent years. Texas has
followed suit, though its overall borrowing
levels and unfunded pension liabilities lie
well within national norms.
Provided the nation does not fall back
into recession, state shortfalls are expected
to gradually recede toward more usual
levels by about 2013. But sizable fiscal
challenges will remain in the areas of infrastructure, education and health as states
struggle to catch up in the aftermath of the
recession and slow recovery. Across the
nation, including Texas, those issues can
be addressed when economic headwinds
diminish.

Chart 6
Texas Pension Funding Exceeds Recommended 80 Percent in 2009

Percent of pension system funded
Less than 80
At least 80 in 2008, less than 80 in 2009
At least 80

Saving is a senior research economist in the Research Department of the Federal Reserve Bank of
Dallas.

SOURCE: Pew Center on the States.

Notes
the nation over the past two decades, with
a slight uptick over the past several years
(Chart 5). This suggests that looking at state
government data alone may provide a misleading impression of the extent to which
Texas is a small-government state. Rather,
Charts 4 and 5 illustrate what economists
sometimes call “fiscal federalism”—the delegation of responsibilities to the smallest government unit able to carry them out. (Florida
is also notable in this regard.)
Such a structure is neither inherently
desirable nor inherently undesirable on economic grounds alone. On one hand, delegating tasks to localities can help government
better tailor the services it provides to the
needs of individual communities and may
improve efficiency by making civil servants
more accountable to their constituents. On
the other hand, it can exacerbate income inequality by impeding revenue-sharing across
jurisdictions and perhaps reduce economies
of scale that larger jurisdictions may produce.
There is some economic evidence that empowering localities can boost state economic
growth, though both state and local debt patterns must be considered when this is done.
States have an additional key liability
not captured by debt-issuance figures: the
degree to which their pension programs are
underfunded. Any time a jurisdiction makes
pension promises to its workers without
adequately setting aside revenue streams
to pay for them, future taxpayer liabilities

1
This article will look primarily at state expenditures. For more
information on the revenue side of the equation, see “Poor State
Finances Deepen Recessionary Hole,” Federal Reserve Bank of
Dallas Southwest Economy, Fourth Quarter 2010.
2
When matching previous spending levels, unadjusted for
inflation and population growth, the figure is $15 billion.
Addressing these factors and compensating for certain previous
spending cuts raises the figure to roughly $27 billion.

are created, even though these promises do
not immediately increase measured state
debt. Media reports have revealed states
with large and under-recognized fiscal gaps
in their pension systems. That liability will
eventually swamp the rest of their debt and
require very large fiscal adjustments. Might
this be true for Texas?
Chart 6 illustrates the extent to which
the continental states have adequately funded
their pension systems. Nineteen states, including Texas, were at least 80 percent funded
in both 2008 and 2009, a benchmark for
sustainable pension systems. In those states,
relatively modest fiscal adjustments should
be enough to maintain solvency over the
medium to long run. Nineteen other states
fell below the 80 percent threshold in both
years, sometimes by a significant margin. In
those states, considerable adjustments may
eventually be necessary, whether they come
in the form of reduced benefits or higher tax
revenues, or both. The remaining 10 states fall
between these two extremes.
Texas doesn’t appear to be an outlier
when it comes to government debt and unfunded pension liabilities.

Meeting Service Needs
State finances have eroded considerably over the last few years, leading to
cutbacks across wide swathes of program
areas nationwide. Texas joined this group
in the 2012–13 budget cycle, addressing a

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

7

SouthwestEconomy

OnTheRecord

A Conversation with Robert D. Hankins

Dodd–Frank: Toward Greater Financial System Stability

Robert D. (Bob) Hankins is an executive vice president at the Federal Reserve Bank of
Dallas, responsible for the Eleventh District’s banking supervisory activities. In July 2010,
Congress approved the Dodd–Frank Wall Street Reform and Consumer Protection Act in
response to the global financial crisis. At almost 2,000 pages, the act spells out new laws
and regulations whose ramifications for financial institutions are broad and complex. In
this interview, Hankins fields questions about the act and its implications.
Q. What are the major goals of the financial

Q. How are institutions going to be supervised?

reforms as laid out in the Dodd–Frank Act?

What changes, in particular, are in store for the
Dallas Fed?

A. The best summary of Dodd–Frank’s goals
is found in its preamble, which states that the
act aims to promote financial stability, end
“too big to fail” (failing banks allowed to continue operating because they are considered
too large to be closed), protect taxpayers by
ending bailouts and protect consumers from
abusive lending practices. Of course, whether
it accomplishes these objectives has been the
subject of a considerable debate.

Q. Dallas Fed President Richard Fisher has

spoken at length about the dangers of financial
institutions that are too big to fail. How does
Dodd–Frank address this? Are the changes likely
to be effective?

A. Protecting the financial system and taxpayers from the consequences of difficulties at
large financial institutions was one of Dodd–
Frank’s main goals. The legislation contains
a number of safeguards and changes to the
supervisory apparatus intended to accomplish
this. For instance, large, systemically important
institutions—and not just banks, by the way—
will be subjected to enhanced prudential supervision, which is to be more stringent and
rigorous than what we do for smaller institutions.
The banking supervision function is also
undergoing some fundamental changes. In
addition to focusing on individual institutions,
we are also taking a more macroprudential
perspective that looks at threats to the stability
of the entire financial system. Finally, Dodd–
Frank implements a new resolution regime
that allows failing financial firms such as large
bank holding companies or other important
financial firms to enter into receivership to fa-

council places on these decisions, it recently
indicated that it will seek additional comment.
So, no firms have yet been named. Any determination requires a two-thirds vote by the
council, including the chairman’s approval.
Even after that, a company has the right to a
hearing before the council, which is required
to submit a report to Congress regarding the
decision. The determination is also subject to
judicial review.

cilitate an orderly wind down of operations.
This option wasn’t available during the crisis
and should help deal with too big to fail.

Q. You said even nonbank firms that are

designated as systemically important will now
be subjected to enhanced supervision. How will
this designation be made? Have any nonbank
firms been identified yet?

A. The Financial Stability Oversight Council,
composed of all major financial market regulators, will determine which nonbank firms are
systemically important. Dodd–Frank lists 10
criteria that the council must consider. These
include things such as size, leverage, interconnectedness and importance as a source of
credit. The council issued an Advanced Notice
of Proposed Rulemaking in October 2010 that
sought input on developing a framework for
making its designations. After getting public
comment, the council issued a formal request
for comment on its proposal of how to select
nonbank firms for enhanced supervision. But,
reflecting the importance and significance the

SouthwestEconomy 8

A. The Federal Reserve is now responsible for
supervising all organizations that are deemed
systemically important. This will include bank
holding companies with $50 billion or more in
assets and the nonbank financial firms that the
Financial Stability Oversight Council decides
are important to financial stability. The Fed will
also be responsible for developing enhanced
prudential standards for these institutions.
The goal is to subject these systemically important financial institutions, or SIFIs, as they
have come to be known, to greater oversight
and more rigorous standards that reflect the
heightened risks they may pose. Things such
as capital requirements, liquidity requirements
and overall risk-management strategies are going to be more stringent for the SIFIs.
As far as the Dallas Fed is concerned, we
have one institution that meets the act’s minimum-size requirement for enhanced supervision, Dallas-based Comerica Inc. Dodd–Frank
also places the supervision of savings-and-loan
holding companies under the Fed, since the
act does away with the Office of Thrift Supervision. For us, that means supervision of about
25 extra organizations, one of which, San Antonio’s USAA, is the largest financial institution
based in Texas.
Q. During the crisis, the Federal Reserve

introduced a number of emergency measures
to help stabilize financial markets. Does Dodd–
Frank affect the Fed’s ability to respond to
future crises?

A. In response to events that unfolded at an
incredibly rapid pace during the crisis, the Fed

FEDERAL RESERVE BANK OF DALL AS • FOURTH QUARTER 2011

“Until someone invents a crystal ball that works, the best we can
do is try to minimize the impact of the next crisis through effective,
though not stifling, supervision and preservation of capital.”
mostly invoked Section 13(3) of the Federal
Reserve Act, which allowed it to lend to any
entity under “unusual and exigent circumstances” as long as five members of the Board
of Governors approved. Dodd–Frank requires
that any such aid program or facility be broadbased and not directed at any one institution.
Also, while the Fed consulted with the Treasury before setting up the various programs,
it wasn’t required to do so. Now, the legislation requires that the Fed gain the Treasury’s
approval before establishing any similar programs or facilities.

Q. Since Dodd–Frank imposes additional

regulation and fees on the banking industry, will
these greater costs affect banks’ ability to lend?
Is there a difference between small and large
banks?

A. Studies have shown that the cost and burden of regulation fall disproportionately on
smaller banks. Larger banks can more easily absorb the increased expense, and that is
why it is important that as much as possible
be done to minimize the impact on smaller
banks. And, of course, the potential impact on
lending for banks of all sizes increases with rising cost structure and staff time devoted to ensuring compliance with laws and regulations.
At the same time, we have seen the result of
reckless lending practices and disregard for
prudent risk management on credit availability
as banks work to repair balance sheets and
rebuild capital. So, I guess the real question
is whether the cost of prevention—the intent
of Dodd–Frank—is cheaper than the cure?
I would argue for the former, but I certainly
understand the frustration felt by those who
played by the rules and who must now bear
some of the burden for those who did not.

Q. What are you hearing from the Dallas Fed’s
district banks? What are the biggest changes
they will confront?

A. As I participate on regulatory panels and
with President Fisher in CEO forums around
the district, the common theme is concern
about the increased regulatory burden and associated cost. The Dallas district consists largely of community banks. While Dodd–Frank

was aimed primarily at enhancing the supervision of the largest organizations that create the
biggest risk to financial stability,
community bankers are concerned about the trickle-down
effect. They are anxious that
Dodd–Frank regulations and
policies adopted by the supervisory agencies will be written
and applied as one-size-fits-all.
The bankers I talk to are worried about how they will absorb increased
compliance costs and remain profitable and
viable, meeting the credit needs of their communities.
To allay these concerns, the Federal Reserve is trying to provide more guidance to
bankers and examiners about what applies to
community banks and what doesn’t. Additionally, the Federal Reserve’s Supervision Committee has established a subcommittee to focus
on the effects of proposed rules on community
banks. Each Federal Reserve district has also
created a Community Bank Depository Institution Advisory Council. A representative from
each of the councils meets twice a year with
the Board of Governors to provide direct feedback on issues affecting community banks.

Until someone invents a crystal ball that
works, the best we can do is try to minimize
the impact of the next crisis through effective,
though not stifling, supervision and preservation of capital. Lessons have been learned and
will be applied going forward. But by their
nature, laws and regulations are backwardlooking, designed to prevent the cause of the
last crisis from being the cause of the next one.

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

A. Legislation this sweeping and comprehensive is bound to be controversial, and Dodd–
Frank is no exception. We’ve certainly heard
many doubts about whether it really ends taxpayer bailouts and too big to fail, and we’ve
heard a number of complaints about increased
regulatory burden. There is also concern about
the inevitable unintended consequences.
These are all valid. But instituting a more macroprudential approach to the supervisory process, along with a new resolution regime for
failing firms, and extending regulatory oversight to important players within the financial
system that aren’t banks are important steps
that hopefully will result in a safer and more
sound financial system.

Q. If the supervisory structure and regulations

in Dodd–Frank had been in effect during the
recent housing boom and bust, do you think the
financial market crisis that ensued would have
been more limited in depth and breadth? Please
explain.

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 crisis. My response is, probably not. Responding
to the savings-and-loan and banking crises of
the 1980s and early ’90s, Congress passed the
Financial Institutions Reform, Recovery and
Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act
of 1991 with the idea they would prevent a
future crisis. Obviously, they did not. To quote
my good friend Thomas Hoenig, who until
Oct. 1 was president of the Kansas City Fed,
“I have a crystal ball on my desk. It doesn’t
work.”

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

9

SouthwestEconomy

Private Equity Industry:
Southwest Firms Draw on
Regional Expertise
By Alex Musatov and Kenneth J. Robinson

The private equity industry
runs the gamut from small
venture-capital investments
in startup companies
to multibillion-dollar
buyouts of well-known
public corporations.

N
eiman Marcus, Harrah’s, Petco, J.
Crew—these well-known names are among
the holdings of companies owned or coowned by private equity (PE) firms in the
Federal Reserve’s Eleventh District. The
region is home to more than 175 PE firms,
including the world’s third-largest, Fort
Worth-based TPG Capital.1 Together, these
entities have raised more than $109 billion
over the past 10 years and sit on $31 billion
pending investment.2
While the PE business model goes
back to the times of early seafaring enterprises funded by limited private partners,
its modern U.S. iteration dates back to the
1950s and the first venture capital funds.
More recently, the industry and its sometimes opaque operations have come under
increased regulatory scrutiny amid concern
about their riskiness and systemic importance to the financial system. Although detailed data are hard to come by, regionally
based PE firms are distinguished from their
counterparts nationwide by the sectors they
favor.

What ‘Private Equity’ Means
The term “private equity” is used very
broadly—often inconsistently—because it
encompasses a vast range of strategies for
investing in companies whose shares are
not publicly traded. In its simplest form, a
PE firm consists of a team of professional
investors who declare their intent to raise
a fund of specified size with an expressed
investment strategy. The team solicits accredited investors—primarily institutional
money managers and high-net-worth individuals—to raise the targeted amount.
Once a fund is closed to additional investors, the firm deploys its capital through
a series of acquisitions, generally occurring
over a period of up to three years. The next

SouthwestEconomy 10

five years or so are spent managing, advising and improving the portfolio of companies.
The final stage of the private equity
cycle—the exit stage—entails divestiture,
with the acquired firms typically operationally stronger and more valuable, reflecting
the PE sector’s benefits to the economy.
Exits can take the form of an initial public
offering of shares or a sale to a corporate
buyer or another PE firm. The full cycle
often requires a 10- to 15-year commitment
from investors, highlighting the long-term,
generally illiquid characteristics of private
equity financing.

Nonpublic Funding
The PE industry runs the gamut from
small venture-capital investments in startup
companies to multibillion-dollar buyouts of
well-known public corporations. They all
share a nonpublic funding structure under
the leadership of a professional general
partner who deploys capital raised from
limited partners. The PE universe is most
often segmented by the life-cycle stage of
target companies—from startups to mature
operations.
“Venture capital” firms invest almost
exclusively in young companies, often before their first revenues materialize. Venture
capitalists are often willing to lose their entire principal on most investments in order
to hit a home run with one potentially revolutionary technology or business method
that reaps enormous returns. The earlier
the stage targeted, the higher the risks and
the greater the potential rewards. In addition to capital, venture capital entities often
provide technical know-how and industry
expertise to their portfolio firms. Google,
Microsoft and Apple are some of the most
illustrious venture capital success stories.

FEDERAL RESERVE BANK OF DALL AS • FOURTH QUARTER 2011

“Growth equity” and “mezzanine debt”
funds target companies in later stages
than venture capital. These PE participants
provide capital—either equity or debt—to
young but stable businesses that require
bridge financing between venture capital and public financing.3 PE firms in this
particular segment hope to capitalize on
rapid growth and typically exit the investment once the firm can access bank loans
or public equity markets. Mezzanine debt
refers to cases when a PE fund opts to lend
to, rather than provide equity in, a growing
firm. The loans typically have very flexible
terms but rank below senior debt in the
event the company defaults. For this added
risk, mezzanine funding comes with relatively high interest rates.
The “leveraged buyout,” or LBO, is by
far the largest and most recognized private
equity strategy. Many think of PE and LBO
as synonymous. LBOs are often involved in
the acquisition of famous brands, combining equity with large amounts of borrowing
to employ significant leverage and gain
control of target companies.
Debt is a key component of this business model because the leverage employed
can amplify the returns generated by an
initial equity investment. Buyout firms target
companies that have strong, predictable
cash flows since those will be needed to repay large borrowings. This makes the buyout segment highly dependent on the debt

markets for financing. The banking industry
plays a key role in LBOs. As of June 30,
U.S. banks reported $115.4 billion in leveraged loans and securities on their books.
In addition to these primary styles,
PE firms pursue various specialized investment strategies. This “other” group includes
firms that invest exclusively in financially
distressed businesses and companies on the
brink of bankruptcy (or already in bankruptcy proceedings) and PE firms that invest in
other PE firms, so-called secondaries.
Funds committed to LBOs account for
the largest relative amount of PE capital
available for investment in each of the major strategies (Chart 1).
Within each segment, PE firms specialize primarily by industry and size of target
firm. With the exception of the largest PE
firms, which tend to diversify across industries, fund managers prefer to acquire firms
within very specific subsegments, often leveraging one portfolio firm to help another
one grow or even merging related business
into a single entity. Narrow industry specialization has been shown to produce higher
returns, and industry participants—including potential acquisition targets—prefer PE
firms with deep experience in a particular
sector.4

Surviving the Financial Crisis

Narrow industry specialization
has been shown to produce
higher returns, and
industry participants—
including potential acquisition
targets—prefer private equity
firms with deep experience
in a particular sector.

The PE industry has largely recovered
from the recent global economic turmoil,

Chart 1
Leveraged Buyouts Are Largest Share of Private Equity Available Capital
Percent of PE available capital
100
90
80
70
60
50
40
30
20
10
0

2003

2004
Venture capital

2005

2006

2007

Growth equity and mezzanine debt

2008

2009
Leveraged buyouts

2010

2011
Other

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

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

11 SouthwestEconomy

A large portion of the capital
attracted during the 2005–08
peak years remains dormant
because of limited profitable
investment opportunities.

reflecting the long-term nature of its model,
with investors committing funds for 10 to
15 years and anticipating a lack of interim
liquidity. The industry, therefore, tends to
experience less instability than equity and
fixed-income markets.5 Still, with the onset
of the financial crisis, PE capital declined
steadily as the inflow of new investment
funding slowed; capital peaked at almost
$900 billion globally in 2008.6
The industry has also been placed under
increased regulatory scrutiny. The Dodd–
Frank Wall Street Reform and Consumer
Protection Act, signed into law in July 2010,
requires that PE and hedge funds as well as
other private pools of capital with at least
$150 million in assets under management
register with the Securities and Exchange
Commission.7 The law also imposes new
record-keeping and disclosure requirements
that will give financial supervisors information
to evaluate both individual firms and the state
of the overall market, closing a regulatory gap
that had existed in this sector of the financial
marketplace.8
The economic downturn and heightened
investor risk aversion affected the industry’s
dynamics. A large portion of the capital attracted during the 2005–08 peak years remains dormant because of limited profitable
investment opportunities. Although investors
curbed some incremental commitments, and
total funds raised contracted after 2008, PE
firms couldn’t spend the large cash positions

they had already built up (Chart 2).
In response, some PE firms diversified
outside of their standard business models,
pursuing alternative investment strategies
that include hedge funds and real estate
funds. In addition, the relative health of
corporate balance sheets has increased
competition for purchase targets. Corporations now periodically outbid PE firms in
auctions for business acquisitions.9

Southwest Private Equity
While PE is global in most respects—
U.S. investment interests can raise money
from a European pension fund and invest
it in Asia—individual firms tend to cluster
near hubs of their target industries. Proximity allows fund managers to build industry
relationships, identify potential targets and
manage a company more actively after its
acquisition. Also, PE firms prefer to hire
insider experts directly from their target industries—and expert staff is often reluctant
to relocate.
Proximity can be especially important
for venture capital firms, which must often
identify promising investments even before
a formal company exists. Out of 29 PE firms
in Austin, for example, 19 focus on high-tech
venture capital. Largely due to the presence
of prominent high-tech companies such as
Dell and a large university population, Austin
is home to almost one-third of all venture
capital firms in Texas.

Chart 2
Ready Capital in U.S. Remains High Despite Decreased Fundraising
Billions of dollars
700
Available capital

600

New funds raised

500

400

300

200

100

0
2003

2004

2005

2006

2007

2008

2009

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

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

12 SouthwestEconomy

2010

2011

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

Southwest

U.S.
7%

Consumer products & services

9%

16%

Business services & media

12%

Energy, oil & gas

10%

14%

17%

11%

Financial services
15%

10%
11%

4%
25%

8%

25%

8%

Hardware, industrial,
manufacturing & infrastructure
Health care, medical,
pharmaceuticals, life sciences
Technology & communication
Transportation, shipping,
logistics, utilities & distribution

Not surprisingly, Southwestbased private equity entities
participate more in energy
industry transactions, given

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

the region’s traditional focus

SOURCE: Prequin.

This locational aspect of the PE industry suggests that PE firms based in the
Southwest (defined as Texas, Louisiana,
New Mexico and Oklahoma) might differ somewhat in their focus. PE firms both
nationally and in the region invest across a
wide number of industries (Chart 3). Not
surprisingly, Southwest-based PE entities
participate more in energy industry transactions, given the region’s traditional focus on
oil and gas.
Of all PE transactions by regional firms
since 2005, 11 percent targeted the oil and
gas sector, almost triple the national rate
of 4 percent.10 In contrast, Southwest PE
firms are somewhat less concentrated in the
technology and communication sector (10
percent versus 14 percent nationally) and
in business services and media (12 percent
versus 16 percent nationally). Southwest PE
firms tend to invest in other industry groups
in fairly similar proportions to national
trends.

Regional Advantage
PE is an important source of capital for
emerging companies and mature corporations. Firms in the four-state Southwest region
hold $31 billion in ready-to-invest capital, a
significant amount in the context of the $51
billion in business loans on the books at
banks in the Federal Reserve’s slightly smaller
Eleventh District.
Like much of the financial services industry, PE is in a period of transition borne
of economic turmoil and regulatory change.

Some firms have moved outside their traditional boundaries. Yet the increasingly global
industry retains its regional flavor, reflecting
a desire to capitalize on the advantages and
specialized knowledge of industries at home.

on oil and gas.

Musatov is an alternative investments specialist
and Robinson is a research officer in the Financial Industry Studies Department at the Federal
Reserve Bank of Dallas.

Notes
As measured by total funds raised in the past 10 years. The
Eleventh District encompasses Texas and parts of Louisiana and
New Mexico.
2
This compares with the U.S. total of $1.65 trillion raised over
the past 10 years and $455 billion awaiting investment, known in
the trade as “dry powder.”
3
Growth equity and mezzanine debt are both very flexible, diverse
strategies and may pursue firms at any stage. For simplicity, we
focus on their preference for mid-cycle companies.
4
See “Playing to Their Strengths? Evidence that Specialization
in the Private Equity Industry Confers 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 because
there is no public market for firms owned by PE investors.
6
All data on the PE industry are from Preqin.
7
Venture capital funds are exempt from 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 for Good Assets,” by
Marietta Cauchi, Marketwatch.com, June 24, 2011.
10
The data in Chart 3 are based on number of transactions. Data
on the dollar amount of investments by industry are available for
roughly 30 percent of transactions.
1

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

13 SouthwestEconomy

NoteWorthy

QUOTABLE: “Texas’ exports face headwinds from two sources: a slowdown
in Mexico and emerging Asia—particularly China—and a stronger dollar.”
—Anil Kumar, Senior Research Economist

PERSONAL INCOME: Further Declines Seen in Texas and U.S.
Many economic indicators in Texas and the U.S. continued to decline in 2010 even though the recession ended
in 2009. While Texas still lags behind in certain key measures of citizens’ well-being, some of the gaps appear to be
narrowing.
Texas’ real median household income fell 1.6 percent
to $47,464 in 2010, compared with a U.S. reduction of 2.3
percent, or more than $1,100, to $49,445, according to the
2011 Current Population Survey Annual Social and Economic Supplement.
Texas’ lesser decline allowed it to move closer to the
national income level than it has been since 2001.
The share of Texas residents without health insurance

decreased 1.5 percentage points during 2010 to 24.6 percent. The U.S. recorded a 0.4 percentage-point drop to
16.3 percent. While Texas experienced the fourth-largest
decline in such coverage gaps in the U.S., the state continues to have the largest percentage of people without
health insurance—3 percentage points greater than in New
Mexico, the next-highest state.
The Texas poverty rate increased to 18.4 percent in
2010, a year-over-year increase of 1.1 percentage points.
The national poverty rate rose to 15.1 percent, up 0.8 percentage points. The national and state rates climbed to
their highest levels since the early 1990s.
—Christina Daly

RECORD DROUGHT: Agriculture Losses Estimated at $5.2 Billion
Texas’ agricultural sector is tallying up record losses
due to an unprecedented drought. The 12 months ended
in September were the driest since recordkeeping began
in 1895. The U.S. Drought Monitor found 92 percent of the
state in extreme or exceptional drought as of mid-October.
Crop and livestock losses are estimated at $5.2 billion,
or 25 percent of usual agricultural production value, according to the Texas AgriLife Extension Service at Texas
A&M University. The total surpasses the previous record for
costliest drought of $4.1 billion in 2006.
Low yields and crop abandonment at a time of high
commodity prices produced losses of $1.8 billion in cotton,
$750 million in hay, $327 million in corn, $243 million in

wheat and $63 million in sorghum production. Crop insurance lessened the impact of income losses for many farmers.
The cost to the livestock sector was $2.1 billion, with
82 percent of pastures and rangeland in very poor condition and hay prices increasing twofold to threefold from a
year ago. Ranchers culled herds due to water and feed conditions, depressing market prices in the short term. However, prices remain relatively high, mitigating the effect.
In addition, the drought lowered income for agriculture workers and sales of farm services and supplies such
as gins, elevators and fertilizer. AgriLife Extension estimates
the sum of direct and indirect losses at $8.7 billion this year.
—Yingda Bi

DEFENSE SPENDING: Economic Benefit Likely to Diminish in Texas
National defense strongly influences the Texas economy
through 20 area military installations and the companies providing them with goods and services. Additional benefits arise
from spending by military personnel and by the Defense Department on aircraft and equipment produced by area manufacturers such as Lockheed Martin and Bell Helicopter.
All told, defense purchases and pay for military and civilian personnel in Texas amounted to $65.6 billion in 2009, or
about 9.7 percent of U.S. defense spending. After accounting
for spillover effects in the local economy from inputs used by
defense contractors and goods purchased by military personnel, total spending in Texas was estimated at $108.6 billion.
Compared with other large states, Texas ranked second

SouthwestEconomy 14

behind California in terms of spending. However, on a per
capita basis, Texas was ninth at just under $3,500.
The Base Realignment and Closure program instituted
in 2005 and ongoing conflicts in Iraq and Afghanistan led to
a military influx that had boosted Texas infrastructure investment, particularly benefiting Fort Bliss in El Paso and Fort
Sam Houston in San Antonio.
However, the outlook is less rosy. Military spending in
Texas will likely fall amid overall defense reductions beginning in 2012 as part of deficit-cutting measures by Congress.
Spending in Texas will decline to $51.7 billion by 2015, a 21.2
percent drop from 2009, Defense Department estimates show.
—Jackson Thies

FEDERAL RESERVE BANK OF DALL AS • FOURTH QUARTER 2011

SpotLight

Texas Employment

Gains Aren’t Simply a Low-Wage Jobs Story

A
mid reports of the nation’s weak economic recovery, high unemployment and
slow job growth, attention has turned to Texas, the only large state on track to surpass its
prerecession 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 for the rest of the
states.1 Texas added 827,000 jobs, an 8.7 percent increase, between 2001 and 2010 and expanded in every category except manufacturing, information and construction. The nation
lost 2.8 million jobs during that period, a 2.3
percent decline.
Texas has benefited from a range of
factors, notably high commodity prices, particularly oil, and development of new drilling
technologies. Rapidly growing exports, high
population growth and robust in-migration of
people and businesses also contributed. Relatively healthy banks and the lack of a housing
bubble cushioned the blow of the recession.
State job gains, which have benefited
from strong fundamentals, have been relatively
rapid and broad based. Even so, the wage picture is mixed.
Of the 22 major occupational categories
surveyed by the Bureau of Labor Statistics, employment rose in 18 of them in Texas versus 11
in the rest of the states between 2001 and 2010
(Chart 1).2 Texas jobs grew fastest in community and social service, which has a median
hourly wage of $19, higher than the $16 median for all U.S. jobs in 2010. Other rapidly
growing categories include health care support, with a median wage of $10; personal care
and service, with a $9 median, and business
and financial operations, with a $29 median.
While more lower-wage jobs were created, higher-paying positions grew at a faster
rate in the state, making up an increasing proportion of total jobs. Texas jobs in occupational categories with wages above the U.S. median increased 11.9 percent from 2001 to 2010,
while jobs with wages below the U.S. median
rose 7.9 percent. That translates to 391,000
higher-wage jobs and 470,000 lower-wage
ones. Positions in occupational categories paying more than the U.S. median accounted for
36.4 percent of total Texas jobs in 2010, up
from 35.5 percent in 2001.
Despite the expanding share of high-wage

Chart 1
Texas Sees Job Growth in High- and Low-Wage Occupations
Community and social service
Health care support
Personal care and service
Business and financial operations
Health care practitioners and technical
Arts, design, entertainment, sports and media
Education, training and library
Computer and mathematical
Food preparation and serving related
Protective service
Legal
Sales and related
All
14
13
9
34
15
18
26
14
42
10
–50

–40

–30

–20

–10

19
10

Texas
U.S.

9
29
27
19
23
35
8
17
33
11
15
Office and administrative support
Transportation and material moving
Building and grounds cleaning and maintenance
Architecture and engineering
Construction and extraction
Installation, maintenance and repair
Life, physical and social science
Production
Management
Farming, fishing and forestry
0

10

20

30

40

50

Percent change
NOTES: Percent change from 2001 to 2010. Figures beside category labels are Texas median hourly wages, in dollars.
SOURCE: Occupational Employment Statistics, Bureau of Labor Statistics.

jobs, Texas pay started and finished the decade
at about 93 percent of U.S. levels (Chart 2).3
Clearly, state wages fluctuated with the business cycle, falling during the jobless recovery
of 2003–04 and rising in 2009–10. While real
(inflation adjusted) wages in Texas increased
from $14.87 in 2001 to $15.14 in 2010, they remain below U.S. levels. The difference reflects
a lower cost of living. However, Texas workers
are also younger and less educated, on average, and more likely to be foreign born.
While Texas wages trail those of the U.S.,
job creation does not appear to be disproportionately low-wage. State trends over time resemble those of the U.S., with lower wage levels best explained by demographic differences.
—Pia Orrenius and Yingda Bi

Chart 2
Texas Wages Lag Behind U.S. Pay
Median hourly wage (real dollars)
17

U.S.

Percent
Texas share of U.S.

16

94

93

15
92
14
91

13

12

’01

’02

’03

’04

‘05

’06

‘07

’08

‘09

‘10

90

SOURCE: Occupational Employment Statistics, Bureau of Labor
Statistics.

Notes
Texas employment uses Federal Reserve Bank of Dallas
employment data, while employment for the rest of the states
is calculated using U.S. National Survey data minus Texas
employment. Using Bureau of Labor Statistics data for Texas and
the sum of states, Texas employment has grown 3.2 percent,
compared with 0.7 percent for the rest of the states.
2
Occupational Employment Statistics from the Bureau of Labor
1

FEDERA L RES ERV E BA NK OF DALL AS • FOURTH QUARTER 2011

Statistics provide annual data on employment and wages by
detailed occupation at the state and national levels. Wages
are expressed in 2010 dollars and exclude the value of fringe
benefits. Wages have been deflated using CPI-U, the Consumer
Price Index for All Urban Consumers, in Chart 2.
3
In 2010, the Texas median hourly wage was $15.14; the U.S.
median was $16.27.

15 SouthwestEconomy

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

PRSRT STD
U.S. POSTAGE

PAID

DALLAS, TEXAS
PERMIT NO. 151

SouthwestEconomy

is published
quarterly by the Federal Reserve Bank of Dallas. The views
expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that the
source is credited and a copy is provided to the Research
Department of the Federal Reserve Bank of Dallas.
Southwest Economy is available free of charge by
writing the Public Affairs Department, Federal Reserve Bank of
Dallas, P.O. Box 655906, Dallas, TX 75265-5906; by fax at 214922-5268; or by telephone at 214-922-5254. This publication
is available on the Dallas Fed website, www.dallasfed.org.

The Texas Service Sector
Outlook Survey
New from the Federal Reserve Bank of Dallas:
a monthly gauge of Texas service-sector activity,
the largest part of the state economy. The Texas
Service Sector Outlook Survey (TSSOS) includes a
special breakout for retail and wholesale businesses, the Texas Retail Outlook Survey (TROS).
The new measurements complement the longstanding Texas Manufacturing Outlook Survey,
the Dallas Fed’s gauge of state factory activity.
Look for the Texas Service Sector Outlook Survey
and companion reports at
www.dallasfed.org/research/surveys

Executive Vice President and Director of Research

Harvey Rosenblum
Director of Research Publications

Mine Yücel
Executive Editor

Pia Orrenius
Editor

Michael Weiss
Associate Editors

Jennifer Afflerbach
Kathy Thacker
Graphic Designers

Samantha Coplen
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