Artificial intelligence lender Upstart (UPST -7.89%) is one of the most popular fintech stocks, based on its following by retail investors. As a result, there has been a lot of controversy over whether the company's underwriting algorithms can revolutionize lending and replace Fair Isaac's traditional FICO credit scoring that has been around for decades. Some argue yes, while for others it's a resounding no.
A big determinant of Upstart's success will be if the credit quality on its loans holds up and if these loans perform better than what traditional banks and other lenders can do on their own. This is especially a concern amid high inflation and as the Federal Reserve hikes its benchmark overnight lending rate, which can put a strain on borrowers.
Let's take a look to see if credit quality has started to deteriorate at Upstart.
Image source: Getty Images.
What's happened so far
Upstart views itself as more of a software-as-a-service (SaaS) company. Its model involves originating loans through its platform and then having banks retain the loans on their balance sheet, or packaging the loans together and selling them to investors through financial instruments such as asset-backed securities (ABS). It's tough to track credit quality on the loans retained by Upstart's bank partners, but Upstart is still selling the bulk of its loans to investors through ABS.
Before the sale of bonds and intermittently through a bond's life, a credit rating firm will go in and thoroughly review the ABS, providing reviews on how they are performing as they age. The reviews include updates on the cumulative net loss (CNL) rates in the ABS and lots of other information on the pool of loans. One such firm, the Kroll Bond Rating Agency (KBRA), provides these reports for free, which is a great tool for investors to use to monitor how Upstart loans are performing.
The information in the table is from the latest KBRA presale report released on March 23 for Upstart's first ABS transaction in 2022, which contains roughly $435.5 million of loans. The report also has information on past Upstart ABS transactions and how they are performing.
| Upstart Securitization Trust | Months Seasoned | Current CNL Rate | Initial KBRA Projected CNL Rate | Current Lifetime KBRA Base Case Loss Projection | Initial Lifetime KBRA Base Case Loss Projection |
|---|---|---|---|---|---|
| 2018-1 | 45 | 12.16% | 21.58% | 13% | 22.10% |
| 2018-2 | 41 | 11.81% | 18.75% | 12.75% | 19.30% |
| 2019-1 | 35 | 11.78% | 19.89% | 14.50% | 21.10% |
| 2019-2 | 30 | 8.24% | 15.59% | 12.25% | 18.25% |
| 2019-3 | 26 | 7.27% | 14.23% | 12.25% | 17.90% |
| 2020-1 | 23 | 5.59% | 11.29% | 11.50% | 16.55% |
| 2020-2 | 16 | 2.85% | 10.44% | 11.00% | 17.60% |
| 2020-3 | 16 | 2.76% | 9.07% | 11.00% | 17.80% |
| 2021-1 | 12 | 3.28% | 7.43% | 17.00% | 18.85% |
| 2021-2 | 9 | 2.70% | 4.35% | 17.00% | 17.35% |
| 2021-3 | 6 | 1.63% | 2.20% | 17.15% | 17.15% |
| 2021-4 | 4 | 0.62% | 0.57% | 14.90% | 14.90% |
| 2021-5 | 2 | 0.07% | 0% | 15.15% | 15.15% |
Data source: KBRA Upstart Securitization Trust 2022-1 presale report.
The number and year on the left-hand side of the table represent the specific ABS, so 2018-1 is the first ABS issued by Upstart in 2018. Months Seasoned represents the number of months since the ABS was first sold to investors. Current CNL Rate is the cumulative net loss rate at the given number of months the ABS is seasoned. Initial KBRA Projected CNL Rate was what the KBRA first projected the CNL to be at the number of months seasoned. The Current Lifetime KBRA Base Case Loss Projection is what the KBRA is currently projecting the lifetime CNL to be once the ABS is fully matured, and the Initial Lifetime KBRA Base Case Loss Projection is what the KBRA projected the lifetime CNL rate to be when the ABS was first issued.
As you can see, for Upstart's early securitizations from 2018-1 to 2020-3, the results are glowing. Current CNL rates are well below initial KBRA projections at the time of the report. The same goes for KBRA's lifetime CNL projections, which are poised to come in much better than when the ABSes were first issued.
So has credit quality deteriorated?
Things have started to tighten up. As seen in the chart, delinquency rates in new ABS vintages are rising quicker in their earlier months than in the past. Also, KBRA lifetime CNL projections for ABS issued in 2021 are for the most part still in-line with initial projections and haven't improved like earlier vintages.
Furthermore, if you look back at the table for the 2021-4 vintage, which was only four months seasoned when KBRA issued this presale report, the current CNL rate is slightly worse than the initial CNL rate projected by KBRA at this point in the ABS' life.
Image source: KBRA.
It's still early in some of these vintages, so delinquencies might level out over time and CNL rates could improve.
There are two other big things to consider. For one, many of the seasoned vintages have been going through periods of time where loan losses, in general, are at historic lows. During the pandemic, which formally hit the U.S. economy in March 2020, consumers had record-high savings rates, largely because there was little they could spend on, and as the federal government provided assistance like stimulus checks and enhanced unemployment benefits.
The second big factor is that Upstart has been applying its underwriting algorithm to more consumers across the credit spectrum, including those with lower credit scores. For instance, in securitization trust 2020-2, there were no Upstart-originated loans made to borrowers with a FICO score of less than 619. But in securitization trust 2021-4, nearly 12.7% of loans in the pool were to borrowers with a 619 FICO score or lower.
It's still too early
The market is anxious for more definitive proof of Upstart's credit quality, but I think it's still too early to make a real determination. Early vintages ABSs that have performed well have aged during a period with extremely benign credit conditions across the banking system. Newer vintages are still in early periods and have many more borrowers lower on the credit spectrum.
The key is focusing less on just delinquency rates and more on how actual results are stacking up against initial KBRA projections. Seeing how these newer vintages pan out is going to be crucial for Upstart's future.
