What happened

Shares of former fintech high-flyers Block (SQ 0.37%), Affirm (AFRM -0.90%), and Upstart (UPST -1.10%) were falling hard today, down 6.9%, 5.7%, and 4.2%, respectively, as of 3:00 PM EDT.

There was widespread selling among unprofitable or highly valued tech stocks today, especially fintech stocks. This could be a continuation of last week's sell-off, as a parade of Federal Reserve governors continued to make media appearances while maintaining their hawkish stances, even in the face of a better-than-expected inflation report on Nov. 10.

That may lead some to conclude the Fed may go too far and spark a recession. With these stocks having recently jumped, it may not be surprising to see investors take some chips off the table.

Block may also be particularly vulnerable in the near term, as it has been a big proponent of cryptocurrencies, especially Bitcoin (BTC 0.32%). That may be a liability in the immediate wake of the FTX scandal, as some fear contagion across the crypto landscape.

So what

Block may be falling in sympathy with Bitcoin, which also fell around 5.1% over the past 24 hours. Of note, Block changed its name from Square due to founder Jack Dorsey's pivot to focus on cryptocurrencies in addition to Block's traditional fintech focus on payments and loans. As of Sept. 30, Block had held $156 million in Bitcoin on its balance sheet, even after impairments.

On Friday, analysts at Mizuho (MFG -1.03%) published a note estimating crypto trading volumes were down 30% to 40% below average on the year, which could continue to hurt the company's crypto trading revenues.

Block also bought its way into the Buy Now, Pay Later (BNPL) space following the $13.9 billion acquisition of Afterpay in February. That makes it a direct competitor with Affirm, just as investors have begun to sour on BNPL platforms.

While it's true that using BNPL offers some advantages over traditional credit cards, investors may be wondering if it's such a great model for them. As inflation bites lower-end consumers and a potential recession looms, there is a lot of fear out there regarding the underwriting of these unsecured short-term loans. On its recent earnings release, Affirm was upbeat, and its charge-off metrics were only back to fiscal 2020 levels, which were lower than both 2018 and 2019.

Management also stressed that due to the short-term nature of these loans, it could easily tweak its underwriting to adjust for a rapidly changing economy. Still, the skeptics appear to be winning the day today.

And of course, when the broader fintech ecosystem is down, it's likely Upstart will sell off too. Upstart doesn't have any direct exposure to the crypto space, but the stock has been decimated on the rapid rise in interest rates this year. Upstart makes multi-year personal loans and car loans to people with questionable FICO scores, so investors are highly skeptical on the name. Furthermore, Upstart depends on third-party loan buyers, who are fleeing the market as interest rates rise rapidly.

With the path of interest rates and the economy highly uncertain, especially after last week's hawkish Fed comments, Upstart will be unable to grow. It may have to continue using its own balance sheet to issue loans this year, increasing risks to its business model.

Now what

While fintech stocks have been among the worst-hit this year, they also have lots of upside should the broader macroeconomic situation get better and rock-bottom sentiment turn around.

However, it does not appear the Federal Reserve is ready to pivot or loosen financial conditions just yet, and it may take a recession for inflation to come down so that the Fed can relax its tough posture on interest rates.

Unfortunately, that may mean fintechs like Block, Affirm, and Upstart may have to endure their first recessions as public companies before they could move higher again. Block's crypto, consumer, and small business exposure could be a liability in that scenario, as could Affirm's BNPL customers. Yet both are probably less risky than Upstart, which not only faces underwriting questions, but also questions over its entire business model.

Investors looking for upside should tread carefully in these names. If you do, you may want to go into these companies in depth and assess if you think their businesses could handle a decline in activity, along with higher charge-offs in their lending segments. If so, they could be long-term winners from these beaten-down levels. If not, it's best to stay away, as they may not make it to the other side of an economic downturn.