R. Christopher Whalen
Dec 22, 20219 min
December 21, 2021 | Back in June of this year, we asked whether Upstart Holdings (UPST) would prove or discredit the use of “artificial intelligence” or AI in the credit underwriting process. UPST then went on a Fed-fueled tear, combining the hype factor of AI with quantitative easing (QE) c/o the FOMC to rise nearly 300% at one point this year, far outpacing other stocks and even crypto assets of all descriptions. In this Premium Service edition of The Institutional Risk Analyst, we take another look at UPST and also update our readers on the company formerly known as Square, now Block Inc (SQ) as in perhaps blockchain? Founder and CEO Jack Dorsey has stepped down from his other company, Twitter (TWTR), presumably to focus on SQ. Of note, the two very different firms have remarkably similar stock performance over the past six months. Call it karma? Or are both TWTR and SQ just two badly inflated stocks losing altitude as the FOMC ends QE?
Upstart Holdings
We still don’t know whether the new age loan acquisition and underwriting tech behind UPST will stand the test of time in terms of delinquency, but we can say that UPST and SQ both illustrate the asset price inflation that has occurred during the COVID pandemic. The chart above compares UPST, SQ and TWTR. Notice that both fintech stocks exploded during the post-COVID flood of liquidity from the Fed and Congress both.
UPST only went public at the end of 2020, but it quickly replicated the pattern followed by SQ once the FOMC opened the monetary spigots in March of that year. Since peaking back in September, both firms have given up significant ground and SQ is actually down for the full year. The full year total return on UPST, however, is over 250% as of yesterday’s close but down 30% in the past month.
The huge upside in these stocks is driven by market hype and, to be fair, a focus on growth rather than earnings. At $165, SQ is trading at 25x book value compared to only 16x for UPST and 9x for PayPal (PYPL). The only traditional bank anywhere near these valuation levels is the hyper-efficient American Express (AXP) at 5x book. The larger question is whether stocks revert to pre-COVID levels once the crisis has past and more normal credit conditions return.
The good news is that UPST is profitable, but to that question about growth, the jury is still out. UPST had guided analysts to $600 million by Q3 2021 in total revenue but came in light at $544 million. Now the company has guided to $750 million for the full year or plus $200 million, which suggests a down quarter sequentially from the $228 million for the quarter ended September.
UPST is, after all, a point-of-sale (POS) funnel for various types of loans, which are funded and closed by third-party banks like Cross River Bank (CRB). On note, the $12.8 billion asset CRB is a hyper-aggressive depository that serves as the lender for many nonbank firms, but has limited disclosure as a unitary, state-chartered non-member bank based in Bergen County, New Jersey.
As of September 30, 2021, CRB’s loss rate was 2x the average for Peer Group 1. The bank has a high dependence on non-core funding, but has 20% total capital to assets – a measure of the risk involved in some of the bank’s business operations. Below is the organizational summary for CRB from the FFIEC.
With the Fed tightening policy and ending QE, has the boom in nonbank lending also ended? UPST and many other nonbank lenders must answer that question in coming months. One indication of the uncertainty facing UPST is volatility. The UPST equity trades on a beta of 1.7x the average six-month market volatility and SQ is right behind at 1.5x beta.
We give UPST a lot of credit for marketing and promotion, but less so for making any real changes in the world of loan underwriting. The Fed has been explicitly pumping asset prices since 2008 when QE 1 was announced. Now the US economy faces the prospect of sorting out the good assets from the bad after a decade of forced credit creation that arguably is mispriced by several notches of default probability.
More, UPST has created a capital light model that avoids the risk and also much of the revenue from the loan, including the servicing strip. After all, it is the party that funds and closes the loan that owns the asset and owns the risk, even after the note is sold into the secondary market. Now you understand why CRB is sitting on 20% equity capital.
“Cross River Bank and one other bank partner account for a substantial portion of the total number of loans facilitated by our platform and our revenue,” notes UPST in its most recent 10-Q. The relevant section of the 10-Q is below:
"Cross River Bank, or CRB, a New Jersey-chartered community bank, originates a substantial majority of the loans on our platform. In the nine months ended September 30, 2020 and 2021, CRB originated approximately 72% and 58%, respectively, of the Transaction Volume, Number of Loans. CRB also accounts for a large portion of our revenues. In the nine months ended September 30, 2020 and 2021, fees received from CRB accounted for 65% and 59%, respectively, of our total revenue. CRB funds a certain portion of these originated loans by retaining them on its own balance sheet, and sells the remainder of the loans to us, which we in turn sell to institutional investors and to our warehouse trust special purpose entities. Our most recent commercial arrangement with CRB began on January 1, 2019 and has a term of four years with an automatic renewal provision for an additional two years following the initial four year term. Either party may choose to not renew by providing the other party 120 days’ notice prior to the end of the initial term or any renewal term. In addition, even during the term of our arrangement, CRB could choose to reduce the volume of Upstart-powered loans that it chooses to fund and retain on its balance sheet or to originate at all. We or CRB may terminate our arrangement immediately upon a material breach and failure to cure such breach within a cure period, if any representations or warranties are found to be false and such error is not cured within a cure period, bankruptcy or insolvency of either party, receipt of an order or judgement by a governmental entity, a material adverse effect, or a change of control whereby such party involved in such change of control provides 90 days’ notice to the other and payment of a termination fee of $450,000. If we are unable to continue to increase the number of other bank partners on our platform or if CRB or one of our other bank partners were to suspend, limit or cease their operations or otherwise terminate their relationship with us, our business, financial condition and results of operations would be adversely affected.”
“In the nine months ended September 30, 2020 and 2021, one of our other bank partners originated approximately 19% and 34% of the Transaction Volume, Number of Loans, respectively. In the nine months ended September 30, 2020 and 2021, the fees received from this bank partner accounted for approximately 15% and 25% of our total revenue, respectively.”
Of note, UPST discloses that “the current maximum annual percentage rate of the loans facilitated through our platform is 35.99%,” a fact that has led to UPST and its partner banks getting involved in usury litigations in several jurisdictions. The basic problem is that UPST, as a thin POS, is not licensed as a lender. Even though the partner banks are able to avoid much state regulation due to the fact of FDIC insurance, UPST and its capital light model cannot. As UPST states: “There is an ongoing risk that government agencies and private plaintiffs will seek to challenge these types of relationships.”
The relationship between UPST and the lender banks, of course, is the major point of vulnerability in the business model. Unlike Varo Bank, which chose to seek and win a full OCC bank charter with the support of Warburg Pincus, UPST chose to take the relatively easy but higher risk bank of being a loan POS and sales conduit for several banks. Our only question is why does Cross River Bank need UPST? The company states in its latest 10-Q:
“We note that the OCC issued on October 27, 2020, a final rule to address the ‘true lender’ issue for lending transactions involving a national bank. For certain purposes related to federal banking law, including the ability of a national bank to ‘export’ interest-related requirements from the state from which they lend, the rule would treat a national bank as the ‘true lender’ if it is named as the lender in the loan agreement or funds the loan. However, the rule was subsequently challenged by the Attorneys General from seven states and ultimately repealed by Congress pursuant to the Congressional Review Act on June 30, 2021. No similar rule applicable to state-chartered banks was issued by the FDIC, and thus there is no longer a clear federal standard.”
Regulatory risk aside, the big question we have is credit. The only way to test the underwriting of UPST is by following their loans through a down credit cycle. As we said, call us in 2025 when housing is likely to be in the midst of a major correction a la 1980 and 2007. Both of these major down cycles in credit lasted a decade and includes a significant recession.
Just imagine how many of the hundreds of thousands of delinquent residential loans that were kicked down the road via COVID modification schemes in 2021 will begin to re-default in 2022. The same outcome is likely for the small commercial loans made by UPST and dozens of other fringe lenders that erupted from the earth due to the FOMC. It’s 2005 all over again.
Block Inc.
Turning now to SQ, the firm founded by Jack Dorsey in 2009 is starting to show signs of maturity, namely slower growth. In our earlier comment, we noted that SQ is less of a fintech company and more of a payments play comparable to giants such as Visa Inc (V) and Mastercard (MA). Dorsey, however, seems to favor the world of crypto tokens for his corporate identity, thus the name change. Mr. Dorsey may come to regret this decision.
To us, the true value of SQ is in facilitating payments for a growing ecosystem of businesses around the world, not speculating in crypto tokens which we view as a fad that will eventually burn out. Like PYPL, however, SQ’s leadership seems to believe that embracing electronic gambling – the true nature of crypto – is somehow accretive to shareholders.
In the nine months ended in September 2021, SQ generated $13.6 billion in revenue vs $6.3 billion in 2020, a 115% increase. Gross profit was $3.2 billion vs $1.9 billion a year earlier, up just 68%, indicating that the cost of revenue grew faster than revenue. Total operating expenses of $3 billion grew 52% YOY, including a $70 million impairment charge for bitcoin losses.
SQ managed to report $239 million in income for the first nine months of 2021 vs a loss of $81 million in the previous year. The 7% EBIT margin is comparable to other financial services firms. Thus, the question comes: Is SQ really, REALLY worth 25x book value? Our respectful answer to that question is no.
We believe that SQ, which we owned through December 2018, is a good comp for MA and V and should continue to grow with the world of global payments. But we think that the performance of both UPST and SQ over the past 18 months has more to do with QE and the monetary policy of the FOMC than any intrinsic value created by Mr. Dorsey. Once these and other financials start to trade on fundamentals rather than asset price inflation expectations, then we believe that the valuations are likely to return to earth.
Disclosures: L: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC
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