R. Christopher Whalen
Jun 2, 20227 min
June 2, 2022 | Back in June of 2021, we noted that the nonbank lending platform Upstart Holdings (UPST) was not so new after all. The originate to sell model crafted by this band of former Google employees had the same risk characteristics as the non-banks that caused the 2008 crisis, namely exposure to market risk. The fact of UPST using “AI” to make lending decisions only made us more skeptical given our experience in the world of decision engineering for loan underwriting. "AI" is simulated cognition, not intelligence.
Wind the clock forward 12 months and our worst fears have been realized. UPST is in the tank in terms of the equity market value, down 65% in the past year due to the changes in the credit markets. More, a growing crowd of trial lawyers are suing the company for securities fraud. Yet the company's earnings are up compared to Q1 2021. What's the problem? The table below comes from the most recent UPST earnings report.
After restating financials and moving loans from “held for investment” to “available for sale,” UPST recorded a negative $19 million fair value mark and essentially had to come clean about warehousing loans on balance sheet. Has the originate-to-sell model that seemed to allow UPST print money and pass the risk on to "partner" banks become extinct? And, please tell us, why are the CSUITE at UPST providing forward guidance to the Street?
Total losses due to adjustments to fair value and other factors was $38 million, this on top of a $24 million fair value adjustment in Q4 2021. More, UPST has $675 million in variable interest entities (VIEs) that it claims are unconsolidated and for which UPST has disclosed a net exposure of just $15 million. If the nonbank lender was quietly hiding unsalable loans on balance sheet, what does this say about the investors?
As we all recall from the collapse of Citigroup (C) in 2009, off-balance sheet can become on-balance sheet risk in a few hours once investors start demanding their money back. As delinquency rises, UPST will be in danger of triggering ABS thresholds that will require accelerated payoffs for senior tranches of deals. In that scenario, the juniors simply have to wait until the senior investors are paid, all this while the FOMC is raising interest rates.
“The average loan pricing on our platform has increased more than 300 basis points since October,” UPST CEO Dave Girouard told investors on May 9th. “In addition to increasing rates for approved borrowers, this also has the effect of lowering approval rates for applicants on the margin.”
The other big issue facing UPST is the credit performance of its loans. As we have written previously in The Institutional Risk Analyst, the positive impact of COVID loan forbearance on visible default rates is ended. We now expect to see loan delinquency rates for UPST and other lenders rise above pre-COVID levels, reflecting the lending volumes possible due to the gold-rush mentality that prevailed in the capital markets between Q1 2020 and today.
“The unprecedented level of government stimulus caused the majority of these post-COVID vintages to overperform significantly,” says Girouard. “The abrupt termination of these stimulus programs has caused some of the more recent vintages to underperform. And finally, we're confident that our models are currently well calibrated to the latest consumer credit conditions, performing in line with expectations and are more accurate than at any time in our history.”
UPST CFO Sanjay Datta summarized the market risks that have sent UPST into a tailspin in the equity markets: “Net interest income was a negative component of net revenue this quarter as the loan assets on our balance sheet which we mark-to-market each quarter sustained declines in valuation due to the rising interest rate environment.”
One of the big problems we see for UPST is their seemingly obsessive habit of providing forward guidance to investors, a decision which is only creating risk for the company. Obviously the dozen or more analysts that follow this volatile stock want and certainly need guidance, but given the volatility of the UPST business model, perhaps another strategy would be advisable?
We see the big risk facing UPST and similar originate-to-sell shops is the loss of investor appetite for unsecured consumer loans. UPST notes that loans in the company’s ecosystem have risen 300bp in recent months, reducing pull-through for new loans. More, the company’s statement during the Q1 2022 earning call that rising delinquency levels has “stabilized” in recent months seems fanciful.
As we note in The IRA Bank Book for Q2 2022, the positive impact on credit caused by QE has only begun to reverse. ABS investors are extremely sensitive to changes in interest rates and delinquency. Our fear is that UPST is going to eventually lose access to the ABS investors that have powered the company’s growth, an extreme eventuality that could badly hurt the prospects for UPST.
“I think that with respect to our large ABS deals, I don't think there's much concern of breaching triggers,” Datta told investors. “We do some smaller monthly sort of pass-through issuance. And there is a possibility that those triggers will be breached.”
Simon Clinch at Atlantic Equities asked a key question during the earnings call: “I'm kind of surprised to hear that you're using your balance sheet to put some loans on there, which aren't just for R&D purposes. And it strikes me as it's just not a normal course of business for you given you're a platform business for. So I was just wondering what kind of message that might send to your bank partners or to others in the system. Just curious about that.”
If UPST is being forced to use its limited balance sheet to warehouse loans, then this may be the beginning of the end of the story. If investors and partner banks don’t want to buy UPST loans at current market rates, then the game is over in an originate to sell model. Thus we move to the other half of the originate-to-sell binary with UPST, namely Cross River Bank in Fort Lee, NJ.
Cross River Bank
Back in January of 2022, we tempted readers to ponder the fact that Cross River Bank (CRB) was one of the best performing banks in the US. Exploding from $1 billion in total assets to over $12 billion a year ago, CRB was one of the largest PPP lenders during the COVID lockdown. And these pioneering souls are also the largest bank partner for UPST, documenting, funding and closing many of the loans that are originated by this AI-based loan acquisition funnel.
Since Q1 2021, CRB has shrunk by a third as its portfolio of government-guaranteed assets has run off. With $9 billion in total assets as of Q1 2022, CRB has risk weighted assets one quarter of this amount, allowing the bank to function with $800 million or so in capital. The bank has a concentration in commercial exposures and non-core funding that is breathtaking for a bank of this diminutive size. But, again, most of the assets are guaranteed by Uncle Sam.
CRB is a subprime lender, with an average gross yield on its loan book of 7.41% as of Q1 2022 vs 4.14% for Peer Group 3. The bank’s income to average assets is 2x the Peer average, an indicator that suggests that CRB is an outlier in terms of risk. For example, CRB reported a yield of 17% on its MBS book, 10x the average return for Peer Group 3. All of the bank’s treasury investments for liquidity are in private commercial and residential MBS, of note, with no Treasury or agency MBS securities reported. Treasurer Dushyant Abhyankar just departed CRB to join Spencer Savings Bank.
The above-peer yield on the CRB loan book is needed because the loss rate on the bank’s loans, which are 84% of total assets, is 0.18% or 5x the average of Peer Group 3 calculated by the FFIEC. The bank’s past due loans of 6.55% is astronomical and puts CRB in the 99th percentile of Peer Group 3. These PPP loans have US guarantees, but the high level of delinquency may still raise concerns. The bank has already been the focus of congressional attention because of the size of its PPP business.
While the bank’s current income is strong and in the top decile of the group, the unusual business mix and funding profile are concerns. For example, CRB has 51% net non-core funding dependence. The good news is that the bank is shrinking at mid-double digit rates, including a 42% drop in new loans and leases since Q4 2021. CRB looks to be exiting the market and shrinking the balance sheet as quickly as possible. Reading between the lines of the UPST disclosure, one wonders if CRB is still closing and selling loans.
CRB took $61 million to the net income line in Q1 2022, a far cry from the $372 million reported in Q4 2021. Loans held for sale almost doubled in Q1 2022 to $1.3 billion. The bank has cut back on its brokered funding in the latest quarter, but borrowed funds still account for half of liabilities. CRB reports no hedging or derivatives positions, making us wonder how or if the bank hedges its available for sale book.
We expect to see CRB continue shrinking its business back down to the base of $2-3 billion in risk assets. The C&I exposures that currently comprise 70% of total assets will run off over the next year. The big question for the bank and also for UPST is how the loans originated, closed and sold to investors perform in what looks to be the worst credit environment in a decade.
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