After a revenue drop its CEO called “unacceptable,” the leadership at fintech lender Upstart is making a bet on the strength of its ability to underwrite loans with AI.
The San Mateo company is planning to leave some loans on its balance sheet that investors do not want to buy, as concerns about the economy shift Wall Street away from backing riskier consumer debt. Rather than pull back on its lending in response, the company said it will hold some loans as it seeks longer-term capital partners.
"Historically, as soon as there is a whiff of macro risk, credit markets shut down altogether," CFO Sanjay Datta told Protocol. "Our holy grail has always been to convince markets that you can use technology to react more quickly and more precisely to macro risk, and navigate economic cycles, without shutting down."
Upstart is among a long list of fintechs working to answer the doubts of investors as consumer sentiment declines and the economy shifts from the low-interest, stimulus-boosted environment that proved fertile ground for the industry in 2021.
But the company says it is not becoming a balance-sheet lender and has no plans to pursue a banking charter, as other lenders have: It is making a temporary change in response to the market.
Quick and abrupt
Founded in 2012 by former Google executives, Upstart uses an algorithm to identify worthy borrowers overlooked by traditional creditors. As a marketplace lender, it gets most of its revenue from fees for matching financial institutions with borrowers. Personal loans are its main business, but the company has expanded into auto and small-business lending.
Business was good last year. Upstart originated nearly $12 billion in loans and its share price soared from $20 at its December 2020 IPO to $400 in October.
Those good times didn’t last. The firm’s share price has fallen nearly 80% this year, as Wall Street in general has soured on fintech stocks.
Upstart reported $228 million in second-quarter revenue, down 26% from the first three months of the year. That was in line with preliminary earnings the company published in July. But it projects further revenue declines 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.
Upstart facilitated $3.3 billion in loans during the quarter, compared to $4.5 billion in the first. "Lenders and institutional credit investors reacted more quickly and abruptly than we anticipated" to economic uncertainty, Girouard said.
The company said it would like to find more long-term deals from institutions willing to back its loans, rather than rely on one-off purchases. Girouard made Upstart’s case in a blog post accompanying earnings, stating that Upstart’s lending systems have been better at identifying risks than traditional credit scores and its 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 it was holding some loans on its balance sheet at the start 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 did not previously have to worry about, said Andrew Boone, a managing director at investment firm JMP Securities.
JMP has a neutral assessment of Upstart, noting in its second-quarter report that “the company continues to have significant runway ahead as it addresses more credit products; however, we await greater stability in its 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 along with the market.
“Now we can see very clearly that this is of use, it is an asset,” Datta told Protocol. “And we would be myopic to try navigating the current macro choppiness not using an $800 million unrestricted cash pile, just because of some religious edict that we're not to touch it.”
Upstart has no plans to become a chartered bank itself, as its leaders made clear several times during the earnings call. That’s despite other marketplace lenders SoFi and LendingClub becoming chartered through acquisitions in recent years.
Charters bring higher regulatory costs, but they allow institutions to lend off of low-cost deposits. LendingClub CEO Scott Sanborn recently told analysts the firm was “leaning more towards the bank model, being conservative on credit and using our low cost deposit funding to hold more loans for investment and drive recurring revenue.”
Upstart sees a banking charter as a potential impediment to its focus on finding worthy borrowers overlooked because of their credit score.
Banks are “set up to be very robust and survive macro shocks,” Datta said. “But as a result, those entities tend to struggle with a mission of trying to provide capital to Americans who are either less affluent or, through a traditional lens, less credit-worthy.”
Despite the current struggles, it views the marketplace model as the best way to write to keep its loan business growing.
“We set up our mission to partner with banks,” Datta said, “because we want to leverage as much of the capital out there as possible.”
Along with planning changes to the funding of its loans, Upstart also recently indicated it planned to make adjustments to its AI-loan underwriting in response to the changing market. That led to the company’s request to have its no-action letter with the Consumer FInancial Protection Bureau terminated, 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 its algorithms. He said the company uses state-of-the-art fairness testing for its lending models and expects to continue working with the regulator.
“We do continue to have open communication with CFPB and would expect to do so in the future as well,” he said. It’s one more way that Upstart is leaving itself open to change.