With loan demand weakening, Upstart could face more problems ahead

The Artificial Intelligence (AI) Lending Company Reached (UPST -2.11%) will announce its third quarter results on November 8 after a difficult year. The stock is down 84% this year.

As the Federal Reserve aggressively raised interest rates in an attempt to tame inflation, the company faced funding headwinds and potential credit issues, which significantly hampered growth. .

I also think it’s very possible that Upstart continued to face these same issues in the third quarter of the year. Here’s why.

Understand the challenges of financing

Upstart is a fintech company that has developed its own proprietary underwriting algorithms that it claims can assess credit quality better than traditional methods, such as Fair Isaac FICO rating. The goal is also to use its underwriting to help borrowers with lower credit scores access traditional banking products while helping banks acquire new customers efficiently.

Image source: Getty Images.

Upstart is not a bank but rather a technology platform. Loans taken out through the platform can be funded and held by partner banks and credit unions, but the vast majority are purchased by institutional investors.

Investors obtain capital to purchase these loans through funding sources that charge interest that tracks the Federal Reserve’s benchmark overnight lending rate, the Federal Funds Rate. With the Fed aggressively raising rates, institutional investors have faced higher costs of capital, meaning they will want higher yielding loans to maintain their yield thresholds. Upstart will be able to raise the price of loans, but there is a lag and the Fed continues to raise rates. Additionally, rates have risen so rapidly that many borrowers who once qualified for certain loans no longer qualify.

Additionally, the Fed’s rapid rate hikes have many investors worried about a severe recession, which could lead to increased loan defaults. Faced with higher funding costs and the possibility of increased defaults, investors funding and buying Upstart loans are heading for the sidelines until conditions improve.

This makes growth difficult for Upstart as it has no one to buy its loans. Origination volume at Upstart increased from approximately $4.3 billion in the first quarter to approximately $3.1 billion in the second quarter, while revenue increased from $310 million to $228 million. In the upcoming third-quarter report, management forecast revenue of $170 million.

A warning sign

In a harbinger of what could happen for Upstart, another online personal loan company called loan club (CL -1.11%) recently released its third quarter results. The market bank, which also sells the majority of its creations to investors, saw those loans rise from about $2.8 billion in the second quarter to about $2.39 billion in the third quarter.

LendingClub CEO Scott Sanborn said the company has

lending volumes more tempered in market earnings due to the rapidly changing rate environment, temporarily affecting investor demand for loans. With the pace and magnitude of rate changes now larger than previously expected, the anticipated momentum is more meaningful.

In addition, LendingClub’s forecast for the fourth quarter suggests continued pressure on loans being sold to investors, who are apparently willing to wait until the Fed at least slows the pace of its rate hikes.

The boost here for Upstart is that LendingClub is banking a higher quality client overall, with the average FICO score for loans sold to investors around 718 at the end of the third quarter. Upstart lends primarily to close-prime clients, which accounted for just 10% to 12% of LendingClub’s third-quarter start-ups.

Potentially more issues to come

Given what we just heard on LendingClub’s earnings call, and given that the Fed is now expected to raise the fed funds rate 1.4 percentage points higher than the market forecast last July , Upstart may have had a rough third quarter.

The company provided a revised outlook in the prior quarter, so perhaps some of those tough conditions are priced into expectations. Upstart’s management team has discussed trying to add committed capital, so it has a cushion for tough environments like this, but this initiative may take some time to operationalize. . The company may also hold loans on its balance sheet, but the market hasn’t always reacted so well when the company does. The company was designed to be a lending platform, not a bank.

Upstart’s stock is down this year, so it could be on the verge of a rebound if the Fed slows the pace of its rate hikes. But I just don’t like investing in a company that’s so vulnerable to rate hikes. Also, I think management will have to do a better job of convincing investors that credit quality will hold up, especially given the direction the economy may be heading.

Bram Berkowitz has positions in LendingClub and has the following options: Long calls $35 in January 2024 on LendingClub. The Motley Fool holds positions and endorses Upstart Holdings, Inc. The Motley Fool has a Disclosure Policy.

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