II have been largely skeptical of the artificial intelligence lender Start (NASDAQ: UPST)It’s not necessarily a bad business. But, the stock’s value has at times seemed to have gotten 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 especially 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.
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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 can determine the true credit worthiness of borrowers and provide lower losses than traditional banking underwriting. The company’s mission is to replace traditional banks. Fair Isaac’s (NYSE: FICO)Upstart management believes that traditional FICO scoring is restricting too many consumers’ access to credit. This promise has been fulfilled so far. Upstart has been opening its credit card to a wider range borrowers recently. This is evident in reports from Kroll Bond Rating Agency.
This was the topic that Upstart’s CFO Sanjay Datta discussed during the company’s earnings call. According to him, as federal stimulus dwindles, consumer savings rates fall and, most importantly, as the company opens its credit line and serves borrowers on the lower end of credit spectrum, delinquencies will increase. This is especially true because the company still has data on these newer, riskier borrowers. Datta stated that it is okay to expect this as long as the company is able to accurately predict delinquencies, and price the risk appropriately.
Prior stimulus measures have led to historic lows for loan losses among lenders in the banking sector. Datta stated that the stimulus measures are starting their to wear off which the company had anticipated. But, no one has been able to predict how fast inflation will rise, how long it will stay, and how quickly Federal Reserve would increase its overnight benchmark lending interest rate, the federal funds rates. 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.
Another new business, Upstart Auto Lending, could also be in trouble if the rate environment is higher. During the pandemic, car prices have risen 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 regarding pricing the risk appropriately was also a bit difficult to interpret. Upstart’s credit rating is dropping, so it is likely that it is making loans at higher interest rates to cover the risk. Because they know they will lose a lot from this group, subprime lenders typically charge high interest rates. Due to the fact that interest rates are not allowed to exceed 36%, most traditional banks cannot offer them. Usury lawsSo, there would appear to be a limit on how risky banks could get.
Banks using Upstart have the ability to set their own credit parameters. Management has revealed that seven Upstart lenders do not need FICO requirements. But, how far down can Upstart’s bank partner banks go?
Although Upstart could very well change loan underwriting as we already know it, the company still needs proof. 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. BankPartners, who provide low-cost funding through their deposits or through institutional investors who buy loans through Upstart’s loan funding programs, are partners. Upstart loan funding programs were funded by 21% partner banks in 2020. Most of the loans sold to institutional investors. Upstart recently revealed that 16% of loans funded through its platform was retained by partner banks in 2021. You should know that Upstart originated a lot more loans in 2021 and 2020 than in 2020. Therefore, partner banks retained more loan volume in 2021. However, you want to see that number increase.
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 in deposits, which were incredibly cheap over the past two years, banks have built up record levels and dry powder. The financial health of consumers has also been remarkable.
Banks had no place to deposit these deposits. As people and businesses accumulated cash in uncertainty, securities were not yielding much and loan growth was difficult to obtain. Upstart has been an excellent partner for the last two-years. Banks were seeing their margins shrinking due to high levels of cash. However, they had large amounts of capital and the consumer wasn’t in bad shape.
Things are about to change. The Fed could raise rates significantly, which will increase consumer pressure as we have discussed. The cost of debt will also increase, so it could reduce loan demand. Higher rates will eventually lead to higher deposits costs for many banks and credit cooperatives. 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? I haven’t worked in a bank but I know that smaller banks tend to approach credit decisions with a more conservative approach.
Be ready for uncertainty
What Upstart has achieved so far It is stunningInvestors should be aware that Upstart’s business could be negatively affected by a new environment. Although the company had a strong fourth-quarter, I think it needs to go through the upcoming rate cycle and wait to see what happens with the Fed’s balance sheet and bank partner before declaring victory.
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Bram BerkowitzNone of the stocks are held by The Motley Fool. The Motley Fool owns Upstart Holdings, Inc. and recommends it. Fair Isaac is recommended to the Motley Fool. The Motley Fool has a Disclosure policy.
The views and opinions expressed in this article are those of the author and not necessarily those of Nasdaq, Inc.
