Can Upstart Succeed in a Rising Rate Environment?

I’ve been largely skeptical of the AI ​​lender Reached ( UPST -6.86% ), not because it’s necessarily a bad deal, but more so because the stock’s valuation has at times seemed to spiral out of control. There’s no denying that the company had an incredibly strong fourth quarter. Diluted adjusted earnings per share of $0.89 on revenue of $305 million easily beat analysts’ estimates, and I was particularly impressed with the loan origination volume of $4.1 billion over the course of quarter, up nearly $1 billion from the third quarter.

The stock has performed well since the company released its results on Feb. 15. Growth in Upstart’s automotive business appears to be continuing, and Upstart also provided revenue forecasts for this year that exceeded previous analyst estimates.

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But the reason I continue to take a cautious approach to this stock is that Upstart is poised to transition from a very friendly environment to one characterized by rising interest rates, terms much more difficult credit conditions and perhaps less liquidity in the market. This is something I think investors should definitely consider before going all-in on the stock.

Defects could increase

Upstart has developed technology that it claims can assess a borrower’s true credit quality and lead to losses far lower than traditional bank underwriting. The company’s objective is to replace Just Isaac’s ( FICO -2.11% ) traditional FICO scoring, which Upstart management says prevents too many consumers from accessing credit. So far, the company has delivered on that promise. But recently, as Upstart has begun to open its credit box to a wider range of borrowers, its delinquency rates have started to rise, which can be seen in reports from ratings agency Kroll. Jump.

Upstart CFO Sanjay Datta spoke about it during the company’s recent earnings call. He said as the federal stimulus fades, consumer savings rates are falling, and especially as the company opens its credit box and serves borrowers at the bottom of the credit ladder. , delinquencies are bound to increase, at least initially and especially as the company continues to gather data on these newer, riskier borrowers. Datta added that as long as the company can correctly predict defaults and assess the risk appropriately, this is acceptable and predictable.

Lenders across the banking system have seen all-time lows in loan losses, largely due to past stimulus. But as Datta mentioned, stimulus is starting to fade, which the company anticipated. What no one really anticipated, however, was how fast inflation would rise, how long it might stay, and how fast the Federal Reserve would raise its benchmark overnight lending rate, the federal funds. Some banks now think the Fed could make seven rate hikes this year.

Consumer debt tends to see higher default rates and rate hikes, as well as a drop in savings, which could hit unsecured debt hard, especially for borrowers at the bottom of the market. credit scale.

Upstart’s other new auto loan business could also struggle in a higher rate environment. Car prices have skyrocketed during the pandemic. If the value of the cars falls below the principal outstanding on the loan, lenders will have a very hard time recovering the remaining value of the loan if borrowers stop making payments.

I also found Datta’s comment on appropriate pricing of risk a little difficult to interpret. As Upstart moves down the credit spectrum, it is likely to make loans that would require higher interest rates to account for the risk. For example, normal subprime lenders charge huge interest rates because they know they are facing massive losses from this group. But most traditional banks can’t offer interest rates above 36% due to usury laws, so there would apparently be some limit to how much risk banks could actually take.

Banks using Upstart can set their own credit metrics, and management revealed that seven lenders using Upstart no longer have FICO requirements, but how far can Upstart banking partners really go?

Upstart may very well change loan underwriting as we know it, but the company has yet to prove it. It will get that chance with the coming rate cycle and when consumers don’t have as much money left.

Will banking demand continue to grow?

Upstart funds its loans in two ways: through original banking partners, who provide a low-cost source of funding from their deposits, or through institutional investors who purchase the loans through the funding programs loans from Upstart. In 2020, partner banks retained 21% of loans funded through Upstart, while most of the remaining loans were sold to institutional investors. In 2021, Upstart recently revealed that partner banks retained 16% of loans funded through the platform. Now that number is bigger than it looks because Upstart originated far more loans in 2021 than in 2020, so partner banks retained more overall loan volume than in 2020, but ideally, you want to see this number go up, not down.

As Upstart now has 42 banking partners, which has probably at least doubled since 2020, I wonder to what extent Upstart can continue to grow banking partners and get them to remove FICO requirements, given the environment of credit and money approaching, which should be completely different from what we have experienced.

When the pandemic hit in March 2020, both short-term and long-term interest rates hit historic lows. Banks have accumulated record levels of cash and dry powder from the influx of deposits, which have been incredibly cheap over the past two years. Consumers were also in an extraordinary financial situation.

On top of that, the banks had nowhere to put these excess deposits. Securities were yielding very little and loan growth was hard to come by as individuals and businesses hoarded cash amid uncertainty. So, for two years, working with Upstart has made sense. Banks were seeing their margins eroded by high levels of cash, they had plenty of capital, and the consumer was in great shape.

Now things are about to change. The Fed could raise rates significantly, which will put pressure on the consumer, as noted above. It can also reduce the demand for loans as the cost of debt rises. Higher rates will also eventually increase the cost of deposits for many banks and credit unions. Then you have to wonder what will happen to the excess deposits in the banks if the Fed starts shrinking its balance sheet and actually withdrawing liquidity.

If consumer credit becomes a concern and deposits decrease and become more expensive, will the board of a small bank want to get rid of FICO requirements, or those already risky unsecured personal loans, by especially with loan growth in other categories? I’ve never worked in a bank, but smaller ones tend to be very conservative credit decisions.

Prepare for uncertainty

What Upstart has done so far is impressive, but investors need to understand that the economy is about to enter a completely different environment, which could significantly affect Upstart’s business. The company had a very strong fourth quarter, but I still think it needs to get through this upcoming rate cycle and see what happens with the balance sheet of the Fed and its banking partners before declaring victory.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end consulting service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

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