Upstart (UPST -4.38%) has had a rough go of it ever since the Federal Reserve began raising interest rates more than a year ago. The artificial-intelligence-assisted lender's stock is down more than 85% over the past year.
And now another big risk has emerged. The Federal Deposit Insurance Corporation (FDIC) recently announced that on March 8, it entered a consent order with the privately held Cross River Bank. Cross River helps a lot of fintech companies offer banking services from behind the scenes, and Upstart does a lot of business with Cross River.
If Cross River has to pull back or limit its business with Upstart, that will exacerbate the challenges the company is already facing.
A key funding partner
Upstart is in the business of originating personal and auto loans for consumers, but the company is not a bank. It really specializes in developing algorithms that attempt to better assess credit quality than more traditional methods. Upstart partners with third-party banks to originate the loans processed through its platform, and those loans are either sold to secondary investors or funded and retained by banks and credit unions.
Cross River is one of the two banks that originate most of the loans processed through Upstart's platforms. According to Upstart's annual regulatory filing, Cross River Bank originated 51% of the loans processed through the platform, and fees received from Cross River accounted for 45% of total revenue in 2022.
The FDIC's consent order suggests that Cross River had been involved with unsafe banking regulations related to fair lending laws. Because Cross River Bank partners with so many fintech companies, it does seem like the order is targeted at these operations.
A spokesperson from Cross River told American Banker that the order is connected with activity by the bank in 2021 and the bank has since "made significant enhancements to our fair lending and other programs including investing in technology and personnel" that will be completed this year. The spokesperson added that the consent order does not place restrictions on the partnerships Cross River has in place with fintech companies like Upstart.
If Cross River went away, I do think Upstart could likely find another bank to pick up the slack on originations -- potentially FinWise Bancorp, its other main bank partner.
But Cross River has also reportedly been retaining many Upstart loans. According to a recent research note from analysts at Compass Point, Cross River Bank is the largest single buyer of Upstart loans and accounted for 17% of all loan funding in 2022 and 57% of all Upstart loans that are funded by banks and retained on their balance sheets. This is very problematic because although bank funding makes up a small portion of the total overall loan volume, it is the most stable source of funding for Upstart in this high-interest-rate environment.
Currently, secondary investors are not interested in buying Upstart loans because they are facing higher funding costs themselves and are concerned about how credit quality on Upstart loans will hold up, especially if there is a more severe recession. This has led to a huge decline in the number of loans Upstart can originate because the company essentially has nowhere to place the loans right now. My own view of Upstart's path to a more resilient business model was based on getting more banks and credit unions to fund and retain loans.
Upstart's model continues to look broken
While Cross River may very well continue to be able to originate loans for Upstart, this is yet another risk to the funding side of Upstart's model at a time when it really can't afford any more setbacks. The capital markets have all but dried up for Upstart at this point and will likely remain this way until the Fed pauses its rate hikes and investors can catch their breath.
But I was even more concerned to learn that Cross River makes up 57% of banking funding volume, because Upstart has 90 bank partners and I wouldn't have thought that one bank constituted so much of the overall bank funding volume. This in my mind is a problem and suggests that banks and credit unions have either really pulled back or were only doing minimal business with Upstart in the first place. As this rate cycle has demonstrated, relying solely on the capital markets for loan funding is not a good or stable model.
The best future for Upstart is to increase bank funding for its loans, and this recent consent order makes this path potentially harder, which is why I continue to be concerned about the future of this stock.
