The whole premise of Upstart's (UPST +0.69%) business model is that it has developed underwriting algorithms using artificial intelligence that can assess the credit quality of borrowers better than more traditional credit scoring methods such as Fair Isaac's FICO scoring method. Upstart's goal is to open up access to borrowers who would normally be turned away from traditional financial products but who are actually creditworthy borrowers, which would help banks and other financial institutions generate more volume while maintaining or reducing defaults. However, credit quality in more recent Upstart loans has started to deteriorate and spook investors at a precarious time for the economy when many expect to see a recession within the next 12 to 24 months.
If things keep going this way, Upstart may continue to see pressure on its growth this year and maybe next. Here's why.
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Deteriorating credit
Upstart is not a bank, so most of its loans are sold to institutional investors, which either hold them on their own balance sheets or package them into asset-backed securities (ABS) collateralized by Upstart loans and sold to other investors. So the company is heavily reliant on the capital markets to keep funding and buying its loans.
The Kroll Bond Rating Agency (KBRA) analyzes and rates ABS sponsored by Upstart, detailing their delinquency and loss rates and overall performance. Early vintages of Upstart loans have performed well but were also propped up to a certain extent by all of the stimulus injected into the economy during the early years of the pandemic. Since then, credit quality has begun to normalize. In a recently issued pre-sale report for the second ABS Upstart is sponsoring this year, the KBRA has raised its loss expectations for the $545.2 million loan pool.
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The expected loan loss percentage in this ABS is 18.7%, which is up more than 3 percentage points from the first ABS Upstart sponsored this year. The heightened risk profile has also pushed up the weighted average note coupon for this ABS from 4.14% to 6.35%. As risk increases, so do the returns that investors will demand. While Upstart's first and second ABS of 2022 are collateralized by different types of borrowers, their risk profile is not that different.
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As you can see, UPST 2022-2 has a weighted average FICO of 652 compared to 654 in UPST 2022-1. UPST 2022-2 has a smaller percentage of borrowers in the much riskier 619 and lower FICO range but more borrowers in the 620 to 700 range. In the pre-sale report, the KBRA said it increased loss assumptions "to account for more recent static pool loss trends." The KBRA also attributed the increase to a higher concentration of higher-risk 60-month loans.
How credit trends could hurt growth?
In its first-quarter earnings materials, Upstart revealed that it held a small portion of loans that it would normally sell to investors on its balance sheet. Management said that because the environment had gotten more risky and institutional investors were recalculating how to appropriately price the risk, the company was holding loans temporarily to bridge the gap. This was the big reason Upstart's stock fell more than 60% following earnings. As a marketplace model, investors want Upstart to use its technology to originate as many loans as possible but not take any of the risk on its balance sheet.
NASDAQ: UPST
Key Data Points
In its first-quarter earnings call, Upstart management also said that because investors were demanding higher returns, the company had to increase loan pricing on its platform, which has the effect of pushing some borrowers that might have qualified under the old underwriting from qualifying for loans.
Higher loan pricing also brings down transaction volume because some people who would have considered Upstart loans with lower rates may be turned off by the higher interest rates and leave the platform. As rates continue to go up, Upstart expects to see less transaction volume through its platform and as such has lowered its full-year revenue guidance from $1.4 billion to $1.25 billion.
My question is whether Upstart will need to keep raising pricing on its loan platform if credit quality continues to deteriorate and investors continue to demand higher returns for taking on the risk. The Fed may also end up raising its benchmark overnight lending rate by 0.5 points at its June and July meeting, which won't help matters. ABS issuance in the U.S. already dropped 45% in the first quarter of 2022 compared to the same time frame as 2021.
If Upstart can't find enough investors to take on loans, then it would likely be forced to slow growth because we already know how investors react when the company places loans on its balance sheet.
