The rapidly rising interest rate environment proved to be a huge headwind for the artificial intelligence lender Upstart (UPST -1.97%) in the first quarter of 2022. As the Federal Reserve began raising its benchmark overnight lending rate, the federal funds rate, the market -- sensing a newly hawkish Fed -- quickly drove up other short-term rates. This put pressure on loan demand and Upstart's overall business model. In the second quarter of the year, the Fed has continued to be aggressive in its efforts to combat inflation, raising the federal funds rate by 50 basis points (0.50%) in May and then 75 basis points in June. Considering that Upstart struggled in Q1 due to rising rates, is the company once again in trouble? Let's take a look.
Looking at the two-year treasury rate
Upstart runs a technology business, and claims its proprietary loan underwriting models can better assess the credit quality of borrowers for personal and auto loans. In doing so, Upstart hopes to not only produce lower default rates for financial institutions, but also grant borrowers lower on the credit spectrum access to traditional lending products at lower interest rates.
The company is not a bank and it generally doesn't hold any loans on its balance sheet. Instead, its tech is used by banks and credit unions that fund the loans with their own deposits and then hold them on their balance sheets. Upstart can also sell the loans to institutional investors and whole-loan buyers, which is what it does with the bulk of its originations.
But these investors don't have deposits, and rely more heavily on short-term funding that's highly sensitive to changes in interest rates. The most relevant benchmark for the industry is the yield on the two-year U.S. Treasury bill, which has increased significantly this year.
2 Year Treasury Rate data by YCharts
In the first three months of the year, the yield on the two-year note rose roughly 160 basis points as investors anticipated a hawkish Fed. This forced investors buying Upstart loans to recalibrate their return thresholds and reevaluate the risk they were willing to take on. This created a slowdown in funding of Upstart loans. Then the company stepped in and used its own balance sheet to fund a small portion of loans it would normally sell to investors. Straying from its capital-light business model did not make investors happy. The stock declined by more than 60% just days after the earnings report.
Origination volume could suffer
Furthermore, Upstart trimmed its full-year revenue forecast because management said it expected higher rates to continue to hurt loan conversion rates. Higher rates will push some borrowers that were right on the threshold of qualifying for loans outside that threshold, and also lead to some people choosing to forgo borrowing that they might have considered were interest rates lower.
The good news is that while the Fed has raised the federal funds rate much more in Q2 than in Q1, the yield on the two-year Treasury note has not risen quite as dramatically, although it's still up a solid 74 basis points. The chance of a recession or stagflation has also increased dramatically.
The question is did higher rates impact institutional investors as harshly this time around. And will that require Upstart to once again hold more loans on its balance sheet?
The good news for investors is that Upstart's Chief Financial Officer Sanjay Datta said in May that the company would no longer hold loans on its balance sheet, probably because of the harsh response from investors after Q1. The bad news is that Datta said the company would instead reduce lending volume if it runs into funding issues, which would hurt revenue because Upstart's fee-based model is dependent on volume.
Will Upstart cut forecasts again?
It's possible Upstart may cut its revenue forecast again when it reports Q2 results. While the yield on the two-year Treasury note has not risen as much as in Q1, it's still marching higher, and recently topped 3.4% before easing off a bit, creating yet more volatility. Additionally, there is now a much greater likelihood of a recession or stagflation, which may put investors on edge about the financial health of the consumer and lead them to ask for even higher returns. It's also going to be much more difficult for Upstart to find buyers for loans it has originated to borrowers lower on the credit spectrum, who are already much riskier. All of this could cut into total origination volume this year, weighing on Upstart's results.
