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Sometimes it hurts to be on the cutting edge. Just look at



third-quarter numbers.

Giving Chase
Chase bounces after early selloff

The bank's earnings in the quarter missed analysts' expectations by a mile, due primarily to poor results at its private equity arm and its investment bank, both of which have been heavily dependent on the New Economy. Chase, which has long trumpeted its exposure to emerging industries, reported operating earnings of 68 cents per share in the third quarter, 25% below the 92 cents posted in the year-ago period. Analysts had been expecting Chase to make 93 cents per share this quarter, according to

First Call/Thomson Financial


Last month, New York-based Chase announced its intention to buy its crosstown rival

J.P. Morgan

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

, which, in a stark and embarrassing contrast, reported strong earnings Wednesday. Chase's profit shortfall will inevitably lead investors to question whether the bank has the operational strength to take a leading role in a merger of this size and complexity.

In addition, if Chase's stock remains under pressure, it will become harder for the bank to retain employees at the merged institution, since many of their pay packages will include options to buy Chase shares. According to the terms of the merger, each J.P. Morgan share is being exchanged for 3.7 Chase shares. At the time deal was announced, it valued Morgan north of $30 billion. Now, Chase would be paying around $24 billion. Confronted with these numbers, it wouldn't be out of the question for Morgan shareholders to press for better deal terms, or even to consider approaching another buyer.

In a public filing last week, Chase's CEO, William Harrison, and Morgan's chairman, Sandy Warner, said they were pressing ahead with the merger despite the recent slide in the stock prices of Chase and Morgan.

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Chase stock was off $2.94, or 7.7%, to $35 Wednesday. Morgan was down $10.56, or 7.7%, to $127.

The Bad Old Days

Third quarter operating earnings of $905 million were Chase's worst since the third quarter of 1998, when the bank was hit by the Russian ruble devaluation and market problems arising from the near collapse of the

Long Term Capital Management

hedge fund. Chase's numbers clearly show how the big shakeout in tech stocks and bonds are causing as much pain to some banks as the crises of 1998.

J.P. Morgan tracking Chase shares

A sliding Nasdaq shellacked

Chase Capital Partners

, the bank's private equity arm, whose revenue comes from cash derived from selling out of investments and from marking up or down the value of its investments each quarter. Even though Chase Capital realized cash gains of $538 million in the third quarter, the unit ended up showing a loss of $25 million, before operating expenses, due to big markdowns in the value of public securities. And this is not a one-quarter blip: Over the first nine months of the year, Chase Capital's revenue totaled $773 million, down over a third from the same period in 1999.

But even excluding Chase Capital, the third quarter was poor. Without the private equity arm, operating earnings would've been more or less flat at $1.02 billion. Compare that with

Citigroup's 26% jump in earnings, not to mention J.P. Morgan's 16% advance.


Chase's meager profits also come courtesy of depressed earnings at Chase's investment bank, which is reliant on debt underwriting for new economy firms. Appetite for emerging industry bonds has recently dried up. Third-quarter investment banking revenues were up, but expenses jumped 25%. As a result, investment bank earnings declined 9% in the third quarter to $349 million. Though up on the year-ago period, Chase's trading revenue of $603 million was down 25% from the previous quarter.

"We're disappointed in third-quarter results, even when excluding Chase Capital Partners," Marc Shapiro, Chase's vice chairman, said in a conference call Wednesday. On the call, Shapiro didn't hold out much hope for a quick revival in high-yield debt underwriting. When asked if the investment bank would soon start laying people off to cut costs, he said that big expense reductions were already part of the merger plans with Morgan.

While keen to express their continuing support for Chase Capital, Chase execs also admitted that this once-hot unit may find it hard in the near future to match its high historical returns. Chase Capital has produced an average 42% annual return on liquidated investments since it was formed in 1984. "We'd assume that

returns would be somewhat lower than that" in the near future, Shapiro said.

However, Chase claims that it still has some big paper gains in Chase Captial that it could realize if it wanted. The third-quarter cash gains were only 30% of what the bank could've realized in the period, according to Dina Dublon, Chase's finance chief. She added that "over 50%" of the third-quarter gains came from selling out of public securities, as opposed to private market deals. It's not clear, however, if those paper gains have shrunk as tech stocks have tanked since the end of the third quarter.