While lending specalist Upstart Holdings (UPST +0.37%) will report earnings results for the first quarter of the year in a few weeks, earnings are actually not the catalyst at the heart of this article. Yes, earnings will be a catalyst (they almost always are), but one longer-term catalyst that investors should be paying close attention to is the company's first asset-backed securities (ABS) issuance in 2022 and how it performs. The performance of this ABS has the potential to send the stock significantly up or down. Here's why.
A test for Upstart's underwriting models
Upstart claims to have developed artificial-intelligence loan underwriting algorithms that can assess the true credit of borrowers better than traditional underwriting methods such as Fair Isaac's (FICO 1.85%) FICO scoring, which has been around for decades. So far, Upstart has applied its model to the personal loan market and has recently rolled it out to the auto loan market as well, with plans to launch into other lending markets. The success of Upstart will be determined by how well its underwriting algorithms perform.
Image source: Getty Images.
Financial institutions can partner with Upstart and use its platform to originate and retain loans on their balance sheet. But most Upstart loans are still coming to the platform organically, and the company still sells most of its loans to institutional investors while it continues to ramp up its bank partnership model. It does this partly through ABS, which are financial instruments that allow a company to pool loans together and sell them to investors. The investors are essentially paid from the cash flow of borrowers paying off their loans.
Luckily, the Kroll Bond Rating Agency (KBRA) publishes free reports that assess the expectations and performance of these ABS. Although Upstart has sold many ABS in recent years, the reason I am watching Upstart's first ABS report of 2022 is that it has a lot more borrowers at the lower end of the credit spectrum in this pool than it has had in the past.
Image source: Kroll Bond Rating Agency.
In the chart above, the second column from the left is the first ABS report Upstart issued in 2022. As you can see in the FICO distribution chart, nearly 30.5% of the loan pool is made to borrowers with a 619 FICO score or lower. That is much higher than ABS in the past.
Another big part of the Upstart story is that because the company claims to have better underwriting algorithms, it also believes it can more successfully originate loans to borrowers lower on the credit spectrum. The goal is to eventually enable financial institutions to lend to borrowers they wouldn't have considered before and also open up access to credit for borrowers that have traditionally not been able to get it.
NASDAQ: UPST
Key Data Points
On the company's last earnings call, Upstart's CFO Sanjay Datta attributed increased loan origination volume in the fourth quarter of 2021 to lending to more prime borrowers across the credit spectrum and to "bringing more hidden prime borrowers into the lendable universe." This essentially means borrowers with lower FICO scores. Interestingly, the KBRA's base case cumulative net loss expectation for this ABS is between 14.5% to 16.5%, which isn't that different from past ABS -- and in some cases, it's better.
Watch performance carefully
Considering what Upstart is trying to do and that this ABS has a higher proportion of lower FICO-score borrowers in the pool, I think the performance of this ABS could have a big impact on the stock. It's also important because the consumer is going into what is expected to be a much more difficult economic environment than what has been seen over the last couple of years. Inflation is high, the Federal Reserve is planning to raise its benchmark overnight lending rate several times this year, raising the cost of debt, and money from stimulus and savings built up during the pandemic is expected to eventually dwindle.
The KBRA will update the performance of this ABS as the year progresses. If cumulative net loss rates start to perform worse than KBRA projections, that would spell trouble for the stock. If they perform in line or better, that would be a big win for the stock and help prove the legitimacy of its underwriting algorithms. I would monitor this development closely.
