As demand for loans weakens, start-ups may face more problems in the future.motley fool

Artificial Intelligence (AI) Lending Company start-up (UPST -2.02%) will report its third quarter results on November 8th after a difficult year. The stock has fallen 84% this year.

The company is grappling with funding-related headwinds and potential credit issues ahead, severely hampering growth as the Federal Reserve aggressively raises interest rates to keep inflation in check.

Also, I think it’s quite possible that Upstart continued to address the same issue in the third quarter of this year. Here’s why:

Understanding funding issues

Upstart is a fintech company that has developed a proprietary underwriting algorithm that it believes can assess credit quality better than traditional methods. Fair Isaac FICO scoring. The goal is also to use its underwriting to help banks acquire new customers in an efficient manner while allowing borrowers with lower credit spectrum access to traditional banking products.

Image Source: Getty Images.

Upstart is a technology platform, not a bank. Loans underwritten through the platform are funded and held by partner banks and credit unions, but the majority of them are purchased by institutional investors.

Investors obtain capital to purchase these loans through funding sources that charge interest that tracks the Federal Reserve Overnight Benchmark Lending Rate, the Federal Funds Rate. Institutional investors are facing higher costs of capital as the Fed aggressively raises interest rates. Startups can raise the price of loans, but with a time lag and the Fed keeps raising interest rates. Moreover, interest rates have risen so quickly that many borrowers who once had access to certain loans are no longer able to do so.

In addition, the Fed’s rapid rate hikes may cause many investors to fear a deep recession, leading to an increase in loan defaults. Faced with rising funding costs and the potential for more defaults, investors who fund and buy upstart loans will sit on the sidelines until the situation eases.

This makes it difficult for Upstart to grow because no one buys loans. Upstart’s origination volume decreased to approximately $3.1 billion from approximately $4.3 billion in the first quarter. Second quarter, revenue fell from $310 million to $228 million. In the upcoming third-quarter report, management is projecting $170 million in earnings for him.

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Another Online Personal Lending Company Called A Forerunner Of What Will Happen To Upstart lending club (LC 2.78%) recently reported third quarter earnings results. At marketplace banks, which sell the majority of originations to investors, these loans decreased from approximately $2.8 billion in the second quarter to approximately $2.39 billion in the third quarter.

Scott Sanborn, CEO of LendingClub, said the company

The rapidly changing interest rate environment has made the volume of loans in the market yield more constrained, temporarily impacting loan investor demand. The expected dynamics are more important now that the pace and magnitude of interest rate changes are greater than previously expected.

Additionally, LendingClub’s fourth quarter forecast suggests continued pressure on loans sold to investors.

Upstart’s takeaway here is that LendingClub is banking higher quality customers overall, with an average FICO score of about 718 for loans sold to investors at the end of the third quarter. Upstart primarily lends to customers closer to the prime tier and only accounted for his 10% to 12% of his LendingClub loan volume in the third quarter.

More problems may occur in the future

Given what we just heard on LendingClub’s earnings call, and that the Fed is currently planning a rate hike, federal funds rate Upstart, which outperformed market expectations by 1.4 percentage points in July, may have gone through a tough third quarter.

The company provided a revised outlook last quarter, so perhaps some of these challenges are built into its forecasts. It has a cushion against a challenging environment, but it could take time for this initiative to get up and running. The market doesn’t always react so well when the company does this. The company was designed as a lending platform, not a bank.

Upstart’s stock has fallen considerably this year and could pick up if the Fed slows its pace of rate hikes. But I don’t like investing in companies that are so vulnerable to rate hikes. I think I have to do a better job to convince the house.

Bram Berkowitz You have a position on LendingClub and have the following options: Long call at $35 in January 2024 on LendingClub. The Motley Fool holds positions in and recommends Upstart Holdings, Inc. Disclosure policy.

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