Artificial-intelligence-driven lender Upstart Holdings (UPST -0.58%) and the Consumer Financial Protection Bureau (CFPB) recently agreed to remove Upstart from the consumer watchdog's list of accepted "no-action letters (NAL)." The designation essentially grants certain financial technology companies immunity from being charged by the CFPB for violating the Fair Lending Act. The idea is to encourage tech companies to do responsible innovation in the financial services space without fear of enforcement from regulators. Let's take a look at why Upstart and the CFPB are parting ways and whether or not investors should be worried.
Updating Upstart's algorithms
In April, Upstart told the CFPB that it planned to add new variables to its loan underwriting algorithms. The CFPB said it would need time to analyze and consider the changes. As a result, Upstart requested termination of the NAL so it could make the changes in a more expedient manner, a request that the CFPB granted.
Nat Hoopes, head of public policy and regulatory affairs at Upstart, said in a recent blog post that Upstart's "request was motivated by a need to keep our risk models accurate and up-to-date during a period of significant economic change." Hoopes also said Upstart chose to make this move because the CFPB is expected to "de-emphasize regulatory arrangements with individual companies, including the no-action letter (NAL) program."
Soaring interest rates this year have caught Upstart and many others off guard. As a result, Upstart has had to move quickly to update its AI underwriting algorithms and loan pricing in order to account for the new macro conditions, and as investors who purchase Upstart loans figured out what kind of risk they wanted to take on due to an economic environment that now includes the chance of a recession.
In a letter regarding the change, the CFPB also said that it "has never endorsed Upstart's model." Furthermore, the agency said it is worried that the public might believe the NAL means Upstart's new models comply with the Equal Credit Opportunity Act. It also said an existing study already implies the CFPB assisted in developing a part of Upstart's underwriting models, which isn't true.
"In light of the risk that the NAL is misconstrued as an endorsement, the CFPB would need to perform more rigorous monitoring and assessment of Upstart's model and any changes to the model in order to responsibly sustain the NAL," the CFPB wrote in their letter.
The CFPB added that Upstart was right to assume this process would prevent the company from quickly changing its underwriting models. It is possible that Upstart felt it could not wait for the CFPB to change its models given the rapidly changing environment. In the first quarter of the year, the company told investors that it had to hold some loans on its balance sheet that it would normally sell to investors because investors were still recalibrating the amount of risk they wanted to take on and how to appropriately price that risk. The news sent the stock plunging.
Should Upstart investors be worried?
Fair lending laws and the Equal Credit Opportunity Act are all about ensuring that lenders do not factor in race, skin color, sexual orientation, or other similar factors when making a lending decision. Upstart is working to open access to credit for people who may have not previously been able to obtain traditional lending products. The fintech company said in 2020 that it approved 27.2% more Hispanic borrowers than traditional credit underwriting models and with 10.5% lower interest rates. It has also made its platform available in Spanish.
I'm not necessarily worried that Upstart will violate any of these laws. But the fact that the company is losing a layer of regulatory protection is not a positive development in my view. It also seems like Upstart could not wait for the CFPB in April to change its underwriting models because the environment was changing so quickly. Considering there is still lots of uncertainty in the environment, I continue to take a cautious approach with the stock.
