I have largely been a skeptic of the artificial intelligence lender Upstart (UPST 2.72%), not because it's necessarily a bad business, but more so because the valuation of this stock has at times seemingly gotten out of control. There's no denying that the company delivered an incredibly strong fourth quarter. Diluted adjusted earnings per share of $0.89 on revenue of $305 million easily beat analyst estimates, and I was particularly impressed by the $4.1 billion of loan origination volume in the quarter, up nearly $1 billion from the third quarter.
The stock has performed well since the company reported those results on Feb. 15. The development of Upstart's auto business looks to be coming along, and Upstart also provided revenue guidance for this year that exceeded prior analyst estimates.
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But the reason I continue to take a cautious approach to this stock is that Upstart is about to go from being in a very friendly environment to one categorized by rising interest rates, much more difficult credit conditions, and perhaps less liquidity in the market. This is something I think investors should certainly consider before going all-in on the stock.
Defaults could rise
Upstart has built technology that it says can assess the true credit quality of a borrower and deliver far lower losses than traditional bank underwriting. The company's goal is to replace Fair Isaac's (FICO 2.37%) traditional FICO scoring, which Upstart management believes restricts too many consumers from accessing credit. The company has so far been delivering on this promise. But recently, as Upstart has started 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 the Kroll Bond Rating Agency.
Upstart CFO Sanjay Datta addressed this on the company's recent earnings call. He said that as federal stimulus fades, consumer savings rates fall, and most notably, as the firm opens its credit box and serves borrowers at the lower end of the credit spectrum, delinquencies are bound to rise, at least initially and especially because the company is still building data on these newer, more risky borrowers. Datta added that as long as the company can forecast delinquencies correctly and price the risk appropriately, this is OK and to be expected.
Lenders across the banking system have been experiencing historic lows in terms of loan losses, largely because of prior stimulus measures. But as Datta mentioned, stimulus measures are starting to wear off, which the company has been anticipating. What nobody has really been anticipating, however, is how fast inflation would rise, how long it might stay, and how quickly the Federal Reserve would hike its overnight benchmark lending rate, the federal funds rate. Some banks now think the Fed might do seven rate hikes this year.
Consumer debt tends to see higher default rates and rate hikes, as well as a decline in savings, which could hit unsecured debt hard, especially for borrowers on the lower end of the credit spectrum.
Upstart's other new business in auto lending also could be in trouble in a higher-rate environment. The prices of cars have skyrocketed during the pandemic. If car values come down and drop below the outstanding principal left on the loan, then lenders are going to have a lot of trouble recouping the remaining loan value if borrowers stop making payments.
I also found Datta's comment on pricing the risk appropriately a bit hard to interpret. As Upstart moves lower on the credit spectrum, it is presumably making loans that would require higher interest rates to account for the risk. For instance, 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 exceeding 36% due to usury laws, so there would seemingly be some limit as to how risky banks could really get.
Banks using Upstart can set their own credit parameters, and management has disclosed that seven lenders using Upstart no longer have FICO requirements, but how far down the credit spectrum can Upstart's bank partners really go?
Upstart may very well change loan underwriting as we know it, but the company still needs to prove it. It will have that chance with the upcoming rate cycle and when consumers aren't so flush with cash.
Will bank demand keep growing?
Upstart funds its loans in two ways: From originating bank partners, which provide a low-cost source of funding from their deposits, or through institutional investors who purchase the loans through Upstart's loan funding programs. In 2020, partner banks retained 21% of the loans funded through Upstart, while most of the remaining loans were sold to institutional investors. In 2021, Upstart recently disclosed that partner banks retained 16% of the loans funded through the platform. Now, there is more to that number than meets the eye because Upstart originated way more loans in 2021 than 2020, so partner banks did retain more overall loan volume than in 2020, but ideally, you do want to see that number going up and not down.
While Upstart now has 42 bank partners, which is likely up at least double since 2020, I do wonder how effectively Upstart can keep growing bank partners and get them to remove FICO requirements, given the approaching credit and monetary environment, which is expected to be completely different than what we've been in.
When the pandemic struck in March of 2020, short- and long-term interest rates hit historic lows. Banks built up record levels of liquidity and dry powder through the influx of deposits, which have been incredibly cheap for the last two years. Consumers have also been in tremendous financial shape.
On top of this, banks had nowhere to put these excess deposits. Securities were paying very little yield and loan growth was hard to come by as people and businesses hoarded cash amid the uncertainty. So for the last two years, working with Upstart has made sense. Banks were seeing their margins eroded by high levels of cash, they had ample amounts of capital, and the consumer was in great shape.
Now, things are about to change. The Fed could raise rates a lot, which will put pressure on the consumer as discussed above. It may also lower loan demand as the cost of debt rises. Higher rates will also eventually raise the cost of deposits for many banks and credit unions. Then you have to wonder what happens to the excess of deposits at banks if the Fed starts shrinking its balance sheet and effectively removing liquidity.
If consumer credit becomes a concern and deposits shrink and get more expensive, will a small bank's board of directors want to get rid of FICO requirements, or do these already risky unsecured personal loans, especially with loan growth in other categories returning? I've never worked at a bank, but the smaller ones tend to approach credit decisions very conservatively.
Prepare for uncertainty
What Upstart has done so far is impressive, but investors should understand that the economy is about to enter a completely different environment, which could drastically affect Upstart's business. The company had a very strong fourth quarter, but I still think it needs to go through this upcoming rate cycle and see what happens with the Fed's balance sheet and bank partners before declaring victory.
