I have been a skeptic of artificial intelligence lenders. Start ( UPST -6.86% )This is not because the stock is necessarily bad, but because the stock’s valuation has sometimes seemed out of control. It’s clear that the company delivered a strong fourth quarter. The company’s adjusted earnings per share, $0.89, on revenue of $305m easily beat analyst expectations. I was particularly impressed with the $4.1billion of loan origination volume for the quarter, which is nearly $1bn more than in the third quarter.
Since February 15, when the company announced its results, the stock has performed well. Upstart’s auto division is developing well. Upstart also provided revenue guidance that was above analyst estimates.
Source: Getty Images
However, I will continue to be cautious about this stock because Upstart is changing from a friendly environment to one with rising interest rates, more difficult credit conditions and possibly less liquidity. This is something that investors should consider before investing in the stock.
Defaults may rise
Upstart developed technology that it claims can accurately assess a borrower’s credit quality and provide lower losses than traditional banking underwriting. The company’s goal: to replace traditional bank underwriting.Fair Isaac’s ( FICO -2.11% )Traditional FICO scoring, according to Upstart management, is too restrictive for many consumers to access credit. This promise has been fulfilled so far. Upstart recently opened its credit line to a wider variety of borrowers. The Kroll Bond Rating Agency reports that Upstart’s delinquency rates are now on the rise.
This was the topic that Upstart’s CFO Sanjay Datta discussed during the company’s earnings call. According to Datta, as federal stimulus fades consumer savings rates drop. Most importantly, as the firm opens its credit card and serves borrowers at lower credit levels, delinquencies will rise. This is because the company is still gathering data on these riskier borrowers. Datta stated that it is okay to expect this as long as the company can correctly forecast delinquencies, and price the risk appropriately.
Due to prior stimulus measures, lenders across the banking system have experienced historic lows in terms loan losses. Datta said that stimulus measures are beginning to wear off, something the company had been anticipating. However, nobody really knew how fast inflation would rise and how long it would stay at its current rate. Nor did they know how fast the Federal Reserve would raise its overnight benchmark lending rate (the federal funds rate). Some banks believe the Fed could increase its rate by seven times this year.
Consumer debt is more likely to experience higher default rates, rate hikes, and a decrease in savings. This could be a problem for unsecured debt, especially for those on the lower end.
The other business Upstart started in auto lending could also be in trouble in a high-rate environment. The pandemic has seen car prices rise dramatically. Lenders will have trouble recouping loan balances if car values fall below the remaining principal. Borrowers who stop making payments may find it difficult to make their payments.
Datta’s comment about pricing the risk appropriately was also difficult to understand. Upstart’s credit rating is dropping, so it is likely that it is making loans at higher interest rates to cover the risk. Normal subprime lenders, for example, charge high interest rates because they know that they will face huge losses from this group. Because of usury laws most traditional banks are unable to offer interest rates higher than 36%, so there is a limit to how risky banks can be.
Banks that use Upstart can set their credit parameters. Management has disclosed that seven Upstart lenders no longer have FICO requirements. But how low can Upstart’s bank partners go?
Upstart may change loan underwriting, but the company still has to prove it. It will have that chance when consumers aren’t as rich and cash-strapped.
Will bank demand grow?
Upstart finances its loans in two ways. It can either be funded by originating bank partner banks, which provide low-cost funding from their deposits, and through institutional investors, who purchase loans through Upstart’s loan financing programs. Upstart’s 2020 loan funding program saw 21% of loans funded by partner banks, with the majority of loans being sold to institutional investors. Upstart recently announced that 16% was retained by partner banks for loans funded through Upstart in 2021. There is more to this number than meets the eyes. Upstart originated more loans in 2021 that in 2020. Partner banks also retained more loan volume in 2020. However, you would prefer to see that number go up.
Upstart has 42 bank partners now, which is more than double the number since 2020. However, I am curious about how Upstart can continue to grow bank partners and get them to eliminate FICO requirements in light of the new credit and monetary environment.
Short- and long-term interest rate fell to historic lows in March 2020 when the pandemic hit. Through the influx of deposits that have been so cheap in the last two years, banks built up record levels liquidity and dry powder. The financial health of consumers has also been remarkable.
These deposits were not available to banks. Because of the uncertainty, banks and securities had very low yields and were unable to provide loan growth, and people and businesses kept cash. Upstart has been a great partner for the past two years. The banks were losing their margins due to high cash levels, but they had plenty of capital and the consumer was in good shape.
Things are about to change. The Fed could raise rates significantly, which could put pressure on consumers as we have discussed. As debt costs rise, it may also reduce loan demand. Higher rates will eventually increase the cost of deposits at many banks and credit unions. You have to wonder what will happen to excess deposits at banks if Fed starts to shrink its balance sheet and effectively remove liquidity.
If consumer credit becomes a concern, and deposits shrink, and get more expensive than before, will a small bank’s board of directors want FICO requirements removed or do these already risky unsecured loans to personal customers, especially with loan growth in the other categories returning? Although I have never worked in a bank, the smaller banks tend to be more conservative when it comes to credit decisions.
Be prepared for uncertainty
While Upstart’s achievements are impressive, investors should be aware that the economy will soon enter a new environment. This could severely impact Upstart. The company had a strong fourth-quarter, but I think it needs more time to process the rate cycle and see what happens to the Fed’s balance sheets and bank partners before declaring victory.
This article is the writer’s opinion. The official recommendation position of Motley Fool premium advisory may differ from the author’s. Were we motley! Were motley!
