As expected, artificial intelligence lending company Upstart Holdings (UPST -0.94%) reported poor earnings results for the third quarter, missing analyst estimates. The guidance for the fourth quarter is even worse and the stock is tumbling.

Upstart's issues have been well documented at this point. The company needs institutional investors to fund and purchase its loans for it to meet all of the loan demand from borrowers that come to its platform. But higher interest rates and broader economic concerns have pushed investors to the sidelines.

However, on Upstart's third-quarter earnings call, it appeared another issue has emerged for the company. Should investors continue to hold the stock through the turbulence?

Borrower demand is waning

Up until now, the big problem with Upstart had been how dependent the company is on capital markets. Upstart is not a bank, but it originates loans through its tech platform, mainly to near-prime borrowers. The company believes it can assess credit quality better than more traditional methods such as Fair Isaac's FICO credit score and can therefore enable borrowers lower on the credit spectrum to access traditional financial products at better rates.

Person looking at computer.

Image source: Getty Images.

While Upstart does partner with banks and credit unions to fund and retain loans through the platform on their perspective balance sheets, the bulk of its loans are sold to institutional investors who use their own capital sources to fund the loans.

As the Federal Reserve has rapidly raised interest rates this year, this has increased the cost of capital for these investors. And as investors largely expect a recession in 2023, many have headed to the sidelines until conditions are more stable.

But an interesting new development in the quarter is that Upstart is not only finding itself constrained by funding issues, but also by a lack of borrower demand. The platform is seeing fewer loan requests, as demonstrated by its conversion on rate requests, which Upstart defines as the number of loan transactions completed of all the legitimate loan requests it receives through its platform. This number fell from over 13% in the second quarter to less than 10% in the third quarter.

Upstart CFO Sanjay Datta attributed this dynamic to the fact that the tough macro environment is increasing loan defaults. "And when that happens, our models recalibrate, APRs [annual percentage rates] go up, and essentially approval rates and acceptance rates both go down," he said on the earnings call.

So, basically, because loan defaults are on the rise, Upstart's platform is getting more strict on who it approves for loans. Management noted that it approved 40% fewer loan applicants than it would have at this time last year, while charging those applicants on average an 8% higher APR. Datta also said the macro environment in the third quarter resulted in default levels that were 70% higher than they would have been in a "long-run normal macro environment."

While this makes sense, it seems like it could also keep loan volume -- the critical component of Upstart's business model -- down longer. Even if funding issues resolve over the next few quarters, what happens if a recession hits next year and defaults keep rising? Then it seems like Upstart would still be borrower-constrained and see less loan volume.

Should you hold the stock?

While Upstart still believes it will be able to assess credit quality better than competing methods, it seems like the company is still trying to figure out and recalibrate its credit underwriting models.

The environment is undoubtedly tougher than anyone might have imagined, but at this point, I really think Upstart is a show-me story that is still too early to invest in.

The company may very well figure out how to better underwrite credit than other methods. But I'm not convinced this has been fully proven out yet, or that it's enough of an outperformance to make a meaningful difference. In the meantime, near-term headwinds are weighing heavily on the company, so I plan to avoid the stock.