Why Fintech Stocks Crashed Today

What happened

Shares in fintech stocks Upstart (UPDATE -0.44%), Confirm (AFRM 0.67%)and SoFi (SOFI 0.40%) were in crash mode today, with each down between 8% and 9% from 2:27 p.m. ET.

Lately, these beaten-down fintech stocks have been among the most volatile to both the upside and downside, and their movements are largely based on macroeconomic news.

Today happened to be a big market pullback after yesterday’s big rally, as interest rate and recession fears, along with perhaps some end-of-quarter liquidations from hedge funds, likely played a role in their synchronous decline.

So what

Equities have been in freefall in September, particularly tech growth stocks following a recent rise in long-term government bond yields, and fintech stocks appear to be caught up in the selloff.

High-growth young fintech stocks seem to be seen as a risky trade by investors, and investors are fleeing risk today amid so much global uncertainty. Today, US unemployment claims came in lower than expected, reflecting the very tight labor market and potentially fostering “sticky” inflation. That could spur the Federal Reserve to continue raising interest rates at a rapid pace.

If inflation and interest rates continue to rise rapidly, higher interest rates may actually help some mature, profitable banks with low funding costs, but smaller, unprofitable fintechs are likely to see their value decline, as their profitability is still far into the future.

On the other hand, there is also another danger of central banks “exaggerating” in the fight against inflation, and pushing interest rates up until we have a broad recession. This can lead to unemployment and higher repayments for loans. Investors are also likely to take a skeptical stance on these three stocks, as they do not have as long a history of guarantees as large, legacy banks. This is especially true for Upstart, which claims its AI models are a new and better way of underwriting loans than traditional ones FICO score.

Fintech stocks also have the problem of financing their loans when interest rates rise. Large, national banks such as Bank of America (BAC -0.65%), for example, can charge very low deposit rates because of their size, national scale and recognizable brand. This allows them to generate a lot of leverage in net interest income when interest rates rise, as they can charge higher interest rates without having to raise deposit rates as much.

That is not the case with fintechs. For example, Upstart had to resort to using its balance sheet this year to fund some of its loans. It was a departure from the original business model of selling all loans to third-party banks and credit unions, as loan buyers defaulted as interest rates rose rapidly.

For financing, Affirm is dependent on storage facilities, securitizations and other commitments regarding progress. These are generally higher interest options than bank deposits.

Yet even SoFi, which bought a bank charter earlier this year that gave it access to deposits, has had to raise its deposit rate APY up to 2% from August, up from 1.5% as recently as June, to attract depositors.

Basically, the smaller you are and the earlier you are in business as a finance company, the higher your financing costs will be compared to large institutions. That tends to put these companies further out on the risk curve, opening them up to installments.

What now

With these stocks down so much from their highs, between 82% and 95%, they could have significant upside if the economy avoids a recession and interest rates moderate. However, there is considerable uncertainty on these fronts, with most economists skeptical that the Fed can engineer a “soft landing”.

Thus, these former highflyers remain high-risk, high-upside bets that a recession will either be avoided or that it will be shallow and mild. They remain appropriate only for investors who are comfortable making volatile, high bets that can also result in very large losses.