After Upstart Holdings (UPST 0.59%) reported disappointing earnings results for the first quarter of 2022 and lowered full-year guidance, shares of the artificial intelligence (AI) lender have plummeted close to 70% over the last five days.

There were a number of things in the quarter that concerned investors, including funding issues from the capital markets and lower expected transaction volume and conversion rates. But at the core of Upstart's business model is its ability to better assess and underwrite credit. That's the company's value proposition to banks, credit unions, and institutional investors.

If the company can deliver on this, it could still deliver good returns in the long run, so let's look at whether Upstart's credit underwriting algorithms are still outperforming traditional underwriting methods.

Person staring at multiple computer screens.

Image source: Getty Images.

Performance is good, but it's complicated

Upstart has developed its own proprietary algorithms to better assess the true credit quality of a borrower. The company claims on its website that its algorithms are generating 75% fewer defaults at the same loan approval rate as large U.S. banks.

Upstart's goal is to one day replace Fair Isaac's FICO credit scoring, which the company believes improperly locks many people out of access to traditional loan products that they should qualify for. Eleven of Upstart's bank partners have now removed minimum FICO scores in their credit policies.

Upstart Default Rates Information.

Image source: Upstart.

The chart above shows that Upstart's models are doing a good job of quantifying risk. The company grades loans within certain FICO ranges between A-plus and E-minus, with A-plus being the best loans to make and E-minus being the worst loans to make.

For instance, Upstart's A-plus graded loans within the 700-plus FICO range have an annualized default rate of 0.6%, while the annualized default rate for all FICO borrowers with a 700-plus score is 3.4%. An Upstart A-plus graded loan in the 639 FICO score range and below (a borrower category more likely to default) sees an annualized default rate of 1.2% compared to the FICO default rate in this range of 7.7%. So clearly, Upstart scoring has been significantly more accurate than FICO so far. 

But keep in mind that consumers have largely been very healthy since the pandemic started in 2020 due to significant government stimulus and an extremely accommodative policy from the Federal Reserve. These policies together lifted savings rates to all-time highs and in general led to historically low levels of loan losses across the banking system.

Since the government has stopped many of these stimulus initiatives and the Fed has become much more hawkish, Upstart has seen default trends normalize quickly, although they're still performing in line with expectations for the most part.

Upstart Default Trends.

Image source: Upstart.

The majority of Upstart loans are sold to institutional investors. In the first quarter of the year, the company had some issues with this side of its investors base, as rising interest rates and a much harsher economic outlook led investors to demand higher returns, which led to higher loan pricing for consumers on Upstart's platform.

Upstart actually had to hold a small portion of loans it normally sells to investors on its balance sheet, as the institutional side reevaluated the risk it was willing to take on. This is one of the big reasons the stock has sold off so heavily because being able to get loans off of its balance sheet quickly is what makes Upstart's high-growth model possible.

To gain further credibility from banks, credit unions, and the capital markets, Upstart will need to prove over the long haul that its AI underwriting algorithms are superior to that of traditional loan underwriting. Many of Upstart's loans eventually find their way into securitization pools, which is an effective way to allow investors to invest in Upstart loans. The Kroll Bond Rating Agency regularly rates these and provides useful info such as delinquency trends.

Upstart Securitization Delinquency Rates.

Image source: Kroll Bond Rating Agency.

Some of Upstart's more recent vintages have started to see higher delinquencies earlier on than past vintages. Part of this is because Upstart has been originating more loans to borrowers across the credit spectrum, which will naturally result in higher delinquencies. Chief financial officer Sanjay Datta said on the company's most recent earnings call that pre-2021 vintages are expected to outperform, while the two or three recent vintages issued closest to the end of 2021 are expected to underperform. He also said that delinquency trends have been stable for the past 60 days.

Are Upstart's underwriting models outperforming?

Based on the data so far, Upstart's credit underwriting models appear to be outperforming when it comes to quantifying risk, and the bulk of its vintages issued over the last four years are set to outperform.

The problem is that government stimulus and high savings rates during the pandemic have certainly affected performance. Furthermore, Upstart still has to see how delinquency trends hold up through the rate cycle.

I also don't know if simply outperforming FICO is enough to fully prove its model because if defaults and loan losses skyrocket and Upstart only outperforms FICO slightly, lenders might not be willing to pay Upstart its fees for just slight outperformance. Ultimately, I think there's a lot that still needs to play out before Upstart claims victory.