LendingClub's Muted Outlook Spells Even Worse News for Upstart

The landscape has been quite challenging for financial companies over the past 18 months, as the Federal Reserve raised interest rates at a rapid pace, consumers were challenged by inflation, and the possibility of recession caused banks to increase their loan loss reserves, compressing net income.

However, the fintech sector has been especially hard hit. Take a look at the relative performance of the ARK Fintech Innovation ETF against the more plain-vanilla Financial Select Sector ETF over the past year:

ARKF data by YCharts

The reasons are several. First, fintech companies are generally one- or two-product companies, as they are much earlier in their lifecycles than diversified big banks are. Second, there's a perception that fintechs may target a less creditworthy consumer, given that most fintechs tout new ways of underwriting clients overlooked or overcharged by traditional banks. Third, and perhaps most importantly, fintechs tend to have higher funding costs than large banks, which tend to have large national low-cost deposit franchises.

That last factor was particularly acute in LendingClub's (LC 1.36%) recent fourth-quarter earnings report, released on Wednesday afternoon, and why it might portend even worse problems for fallen fintech star Upstart (UPST 3.90%) when it reports earnings in mid-February.

LendingClub is slowing down, and its margins are getting squeezed

LendingClub was still profitable in its most recent quarter, and the company actually beat analyst expectations for both revenue and earnings per share. Yet there were some troubling signs in the report. When combined with a tepid forward outlook, the stock sold off 11% the next day.

LendingClub's results were hit in a couple of different ways. Like Upstart, LendingClub's core product is the unsecured personal loan. While consumers might take out a personal loan for a number of reasons, it's usually to refinance high and variable-rate credit card balances with lower-rate, fixed payments.

When interest rates have risen as rapidly as they have, that immediately hits banks' costs of funding. Usually, after a short delay, credit card companies raise their rates. To maintain their lower-rate advantages, personal loan providers generally have to wait until credit card companies raise rates before raising their rates on personal loans.

Yet despite being the last to "move," fintech companies typically have the highest cost of funding, which adjusts immediately. So last year's rapid increases in the federal funds rate, which tends to immediately increase the interest paid to depositors, hits fintechs hard -- before they can raise loan rates.

LendingClub's net interest margin has compressed as the Fed has moved interest rates higher since mid-2022 in rapid fashion:

Data source: LendingClub Q4 2022 investor presentation.

And tightening credit means lower originations with lower margins

In addition to the rate squeeze, there is also the issue of a potential recession to deal with. LendingClub is responding by tightening credit, intentionally originating fewer loans in the uncertain economic environment. Next quarter, it plans on originating only between $1.9 billion and $2.2 billion in loans, down from the $2.5 billion it originated in the fourth quarter and significantly down from the $3.2 billion originated in the March quarter a year ago.

CEO Scott Sanborn said on the earnings call:

Our delinquencies have outperformed industry averages, but we need to remain vigilant and proactive. We anticipated and have seen pressure on our members, most notably in near prime and especially among those consumers with lower incomes. ... Accordingly, we were proactive to begin tightening early in 2022 and have continued to tighten our underwriting throughout the year. For reference, our fourth quarter near-prime volumes are down more than 50% from their peak.

Image source: Getty Images.

And Upstart is an even worse situation

Keep in mind, the margin squeeze is a high-class problem for fintechs actually lucky enough to have banking licenses and deposits.

While starting off as a pure marketplace, LendingClub became a hybrid model after acquiring Radius Bank in early 2021. Thanks to that acquisition, LendingClub is able to keep originating loans and holding them profitably on its balance sheet, even if margins are squeezed.

But for fintechs like Upstart that don't have deposits, third-party loan buyers may just pause or stop their loan-buying altogether. As rates have risen, the hurdle rate for these loan investors has also increased, so if personal loan rates haven't "caught up" to the rise in the federal funds rate, these would-be buyers might just not buy loans at all, opting for other asset classes. For instance, LendingClub's marketplace originations fell 21% year over year, compared with just an 8% decline in loans held on LendingCLub's balance sheet.

However, Upstart doesn't have the ability to funnel loans to its balance sheet in a big way, because it doesn't have deposits. Not only is Upstart dependent on third-party loan buyers, but Upstart also tends to gravitate toward providing higher-interest loans to those "near-prime" customers Sanborn was warning about in the quote above. That is where the industry is currently seeing increased charge-offs in the inflationary environment.

So not only doesn't Upstart have the ability to fund as many loans as it would like, but its target customer has also been shown to be riskier in this higher-inflation environment. That means loan buyers might be especially hesitant to purchase Upstart loans. That was already seen in the third quarter of last year, when Upstart's originations fell 42% below the prior-year quarter. And if LendingClub's Prime originations have declined significantly since the third quarter, one can imagine Upstart's results could see some pretty ugly declines again when it reports on Feb. 14.

The good news

One positive to keep in mind: When the Fed slows and then pauses rates, those headwinds of rapidly rising rates will go away and potentially reverse into tailwinds. Personal loan rates will reprice, and consumers, squeezed by peak credit card rates, are likely to have high demand for personal loan alternatives. And if investors begin to anticipate a lower federal funds rate in the future, that would lower their cost of capital and lure personal loan buyers back to the marketplace, perhaps just as quickly as they have fled.

The question, of course, is will these fintechs be able to make it to the other side of these rapid interest rate increases, and if so, how their loans will perform in the economy weakens and unemployment rises?

Because of LendingClub's deposit base and tightening of credit, it looks like a safe bet to make it there. For Upstart, it may be more of an open question.