Fintech lender Upstart’s plan for rising interest rates, decline

After a fall in revenue, which the CEO called “unacceptable”, the management of fintech lender Upstart is betting on the strength of its ability to guarantee loans with AI.

The San Mateo company plans to leave some loans on its balance sheet that investors don’t want to buy, as worries about the economy move Wall Street away from backing riskier consumer debt. Instead of pulling back on lending in response, the company said it will hold some loans as it seeks long-term capital partners.

“Historically, as soon as there is a hint of macro risk, the credit markets shut down completely,” chief financial officer Sanjay Datta told Protocol. “Our holy grail has always been to convince markets that you can use technology to respond faster and more precisely to macro risks, and navigate economic cycles, without shutting down.”

Upstart is among a long list of fintechs working to answer investor doubts as consumer sentiment wanes and the economy shifts from the low-interest, stimulus-enhanced environment that proved fertile ground for the industry in 2021.

But the company says it won’t be a balance sheet lender and has no plans to pursue a bank charter, as other lenders have: It’s making a temporary change in response to the market.

Fast and abrupt

Founded in 2012 by former Google executives, the startup uses an algorithm to identify worthy borrowers overlooked by traditional creditors. As a marketplace lender, it derives most of its revenue from fees for matching financial institutions with borrowers. Personal loans are the main business, but the company has expanded into lending to cars and small businesses.

Business was good last year. The upstart originated nearly $12 billion in loans and its share price rose from $20 at its IPO in December 2020 to $400 in October.

The good times didn’t last. The firm’s share price has fallen nearly 80% this year, as Wall Street has soured on fintech stocks in general.

Upstart reported $228 million in revenue in the second quarter, down 26% from the first three months of the year. It was in line with preliminary results the company published in July. But it estimates further revenue decline in the third quarter, to $170 million.

Those declines are “obviously disappointing and unacceptable to us,” CEO Dave Girouard said on Upstart’s Aug. 8 earnings call.

The upstart facilitated $3.3 billion in loans during the quarter, compared with $4.5 billion in the first. “Lenders and institutional credit investors reacted more quickly and more sharply than we expected” to economic uncertainty, Girouard said.

The company said it wants to find more long-term deals from institutions willing to back the loans, rather than relying on one-off purchases. Girouard made Upstart’s case in a blog post accompanying the earnings, stating that Upstart’s lending systems have been better at identifying risk than traditional credit scores, and the loans have consistently delivered returns to investors.

But finding more partners will take time, so Upstart will for now rely on about $800 million on its balance sheet to cover funding gaps between borrowers and investors.

Wall Street analysts already reacted negatively when Upstart revealed that it had some loans on its balance sheet at the beginning of the year – prompting the company to reverse course and sell off the loans. Holding loans introduces risks that investors in Upstart’s marketplace lending model didn’t previously have to worry about, said Andrew Boone, managing director of investment firm JMP Securities.

JMP has a neutral rating on Upstart, noting in its second quarter report that “the company continues to have significant runway going forward as it addresses multiple credit products; However, we are waiting for greater stability in the core business before we become more positive.”

Upstart acknowledged to analysts that it is now going back on what it said publicly by putting some loans on its balance sheet. Datta said the firm’s thinking has evolved with the market.

“Now we can see very clearly that this is useful, it’s an asset,” Datta told Protocol. “And we would be short-sighted to try to navigate the current macro choppiness without spending an unlimited pile of $800 million, just because of a religious injunction that we shouldn’t touch it.”

Unknown territory

Upstart has no plans to become a chartered bank itself, as the managers made clear several times during the earnings call. That’s despite fellow marketplace lenders SoFi and LendingClub being chartered through acquisitions in recent years.

Charters bring higher regulatory costs, but they allow institutions to lend from low-cost deposits. LendingClub CEO Scott Sanborn recently told analysts that the firm is “leaning more toward the banking model, being conservative on credit and using our low-cost deposit financing to hold more loans for investments and drive recurring revenue.”

Upstart sees a bank charter as a potential obstacle to its focus on finding worthy borrowers who are overlooked because of their credit scores.

Banks are “set up to be very resilient and survive macro shocks,” Datta said. “But as a result, these entities tend to struggle with a mission of trying to raise capital for Americans who are either less wealthy or, through a traditional lens, less creditworthy.”

Despite its current struggles, it sees the marketplace model as the best way to write to keep its lending business growing.

“We set up our mission to work with banks,” Datta said, “because we want to leverage as much of the capital out there as possible.”

Along with planning changes to the financing of the loans, Upstart also recently indicated that it plans to make adjustments to the AI ​​loan guarantee in response to the changing market. That prompted the company’s request to have its no-action letter with the Consumer Financial Protection Bureau ended, because the agency said approving such changes would require a lengthy review.

Girouard was asked on the earnings call about working with the CFPB and how the change could affect the algorithms. He said the company uses state-of-the-art fairness testing for its lending models and expects to continue to cooperate with the regulator.

“We continue to have open communication with the CFPB and expect to do so in the future as well,” he said. It’s yet another way Upstart leaves itself open to change.