Although they operate very different business models, both the digital marketplace bank LendingClub (LC -2.08%) and the artificial intelligence lender Upstart (UPST -1.25%) are market leaders when it comes to online personal lending, each having originated at least $10 billion of unsecured personal debt in 2021. While Upstart originated more loans and will likely continue to do so, LendingClub has a big funding advantage, which will be key as interest rates rise and if economic conditions get more difficult. Here's why.
Deposits and bank partners make a difference
Many fintech companies will take all or most of their loan originations and sell them to third-party investors like hedge funds, insurance companies, or asset managers, or pool loans into asset-backed securities (ABS) for investors that can't hold whole loans directly on their balance sheets. Another method is to partner with banks that have their own deposit bases to fund the loans and put them on their balance sheets.
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Upstart's goal is to originate as many loans as possible across the credit spectrum, which is why it tends to originate more loans than LendingClub, which largely focuses on prime borrowers and above. But Upstart also wants to be capital efficient and not hold loans on its balance sheet. In 2021, Upstart's banking partners retained 16% of Upstart's originations on its balance sheet, while 80% of loans were purchased by institutional investors.
The problem with this loan funding model is that when interest rates rise as quickly as they have this year due to the Federal Reserve's desire to get inflation under control, and the risk of a recession significantly increases, institutional investors become less willing to take on riskier loans, and may demand much higher returns, which pushes up loan pricing to consumers. Investors also become much less likely to invest in ABS -- and ABS issuance is down significantly this year compared to 2021.
That's why it's much better to have deposits funding loans, because they cost much less for banks than the type of funding institutional investors typically need to take on. Additionally, as the Fed raises rates there is typically a lag period before banks start having to raise the interest they pay out on deposits.
LendingClub decided to become a bank, and in early 2021 became one of the first fintechs to obtain a bank charter through its purchase of Radius Bank. LendingClub now has $4 billion of deposits and funds anywhere from 20% to 25% of its own originations, which it holds on its balance sheet. On its first-quarter earnings call, LendingClub CEO Scott Sanborn said about half of its originations are funded by partner banks including LendingClub itself, so a much higher percentage of LendingClub loans are funded by low-cost deposits than Upstart.
Less reliant on the capital markets
After Upstart's latest earnings results, its stock price plunged more than 60%. Believe it or not, it wasn't because of the results or strictly because the company lowered guidance. Upstart revealed that as interest rates rose and investors recalculated the risk they wanted to take on, the company had to hold a smaller portion of its loans on its balance sheet that it would normally sell to investors as a way to bridge the gap. Because Upstart's model is focused on originating loans and then quickly getting them off the balance sheet, this was not what investors wanted to see.
Additionally, in Upstart's latest $545.2 million ABS, the Kroll Bond Rating Agency noted that it expects loss rates to be more than 3% higher than the ABS Upstart issued earlier this year, and the note coupon was higher, reflecting more risk. Because Upstart sells the large majority of loans to investors and into the capital markets, investors are worried about these avenues drying up amid the riskier environment, which would likely force Upstart to slow growth.
But LendingClub has made a much more concerted effort to be less dependent on the capital markets. Not only are half of its loans funded by banks, including LendingClub, but on the company's most recent earnings call, CFO Tom Casey said that the company has "deliberately" targeted investors with lower leverage and less exposure to the capital markets specifically to avoid the situation that has played out in recent months. LendingClub also hasn't done an ABS. LendingClub CEO Scott Sanborn said that the number and diversity of loan purchasers in its marketplace is now much higher than pre-pandemic.
I also find it interesting that one of the reasons Upstart had to hold loans on its balance sheet is because its loan purchasing platform for institutional investors is still largely manual, which slows down the process as institutional investors calculate new return thresholds as the risk of loan defaults increases. LendingClub has an automated loan auction platform that can reach market-clearing prices on its loans for investors in just days, allowing the company to quickly adapt to new environments. Recently, LendingClub made it possible for investors on the platform to sell loans directly to one another, which will further increase liquidity in its marketplace.
LendingClub is more prepared for a difficult environment
All of these reasons above make LendingClub much more prepared to deal with an intense rising-rate environment like the one we're in now, largely because it has a much better funding model and is much less beholden to the capital markets. Furthermore, LendingClub's automated loan marketplace can efficiently adapt to rapid changes in the environment. While Upstart may be able to generate more loan volume, LendingClub can absorb market shocks much more fluidly and should be much more durable during market volatility and a down economy.
