Upstart (UPST): A Jump Start On The Road To Financial Hell

Upstart’s Two-Sided Business Model 

Upstart operates a two-sided loan-exchange platform. On one side, millions of consumers seek personal loans for debt consolidation, medical reasons, or auto loans. On the other side, it has about 100 banks purchasing said credit underwritten by Upstart, which it claims to do more effectively than competing banks. It claims this is due to its superior “artificial intelligence” program.

Several of Upstart’s largest loan origination partners are facing severe regulatory issues; two originated 87% of loan value using Upstart’s credit decisioning algorithms. Upstart’s claims it has an artificial intelligence platform that enables it to make better credit decisions, yet results have been horrible. Partner banks have pulled back from purchasing Upstart paper, and loans have begun to pile up on Upstart’s balance sheet. This could be the beginning of a death spiral for Upstart. In the wrong capital markets environment, it would be easy to see this go to pennies per share.

The purchasers of Upstart credit are facing severe regulatory issues, and we believe its largest source of revenue could be shut down by the FDIC in the next twelve months - if history is any indication. Upstart has many looming issues: 

• Upstart’s two largest sources of revenue come from banks with pretty big regulatory issues. 45% of revenue comes from Cross River Bank, a bank we think has the potential to shut down in the next twelve months. 

• Its second largest source of revenue comes from FinWise Bank, which accounted for 28% of Upstart revenue in 2022. FinWise Bank is a “rent-a-bank” that has partnered with some of the most egregious lenders, and is facing potentially increased regulatory scrutiny. 

• The company tells two of its most important constituencies two very different things.  Upstart has aggressively touted its Artificial Intelligence and Machine Learning platform but we think Upstart’s actual AI is uncompetitive, flawed, and does not lead to better credit outcomes. After pushback from the SEC asking it to quantify how its AI is better, it deleted large swaths of claims from its filings but continues to tout its successes publicly while remaining mum on the subject in SEC filings. 

• Loans have started to pile up on its balance sheet, with the company already writing down a substantial amount of bad credit. However, the bad credit performance appears to be trending upwards from our examination of securitization reporting.  Upstart’s revenue and cash balance have been plunging, and we think this could be the beginning of a death spiral. 

• It is clear from the results that Upstart has made aggressively bad credit decisions, which might be what happens when “AI” approves 87% of loans immediately, something the company seems inexplicably proud of.

Initial Disclosure: Bleecker Street Capital is short shares of Upstart. Please see the full disclaimer below.

Upstart “AI” and “Machine Learning” Platform 

Upstart goes to great lengths publicly to align it with the hype around AI and Machine Learning. We have strong views on the claims Upstart has made about its artificial intelligence program. It claims this will lead to more access to credit for everyone.

Upstart pushes its AI hype: 

“We are a leading artificial intelligence (AI) lending platform designed to improve access to affordable credit while reducing the risk and costs of lending for our bank partners. Our platform uses sophisticated machine learning models to more accurately identify risk and approve more applicants than traditional, score-based lending models.” 

Upstart has publicly claimed that its AI platform enables it to make superior credit decisions. We believe this is not true and that the substance behind much of its hype is very flimsy. 

Let’s examine the substance behind Upstart’s AI and Machine Learning claims. Upstart makes specific claims about its AI system. Upstart touts better realized loss rates than the rating agency model in its investor presentations. 

However, these results come from an internal study where Upstart looked at a measly seven securitization transactions between August 2018 and October 2020.

When Upstart was going public, it made many claims about its AI and ML platform that received significant pushback from the SEC and were eventually deleted from filings. Yet Upstart has continued to make these and similar claims publicly. 

Compare the before and after from Upstart’s DRS to its official S-1. 

Vs. the final S-1:

In March and May of 2020, the SEC pushed back on Upstart’s labeling of “the predictiveness of (the) proprietary AI model” and sought “quantitative disclosure” around these improved loss rates in Upstart’s fabled AI loans. After this pushback, Upstart deleted large swaths of claims from its filings. 

Yet, on its homepage, Upstart still claims that the quality of its AI offers “higher approval rates and lower loss rates.” Why do they make this claim? It was based on an even flimsier internal study based on the underwriting policies of just three partner banks (Upstart claims over 100 partner banks). 

We asked some men and women in the arena about Upstart’s AI story. They were entirely unimpressed: 

“The AI underwriting model was unimpressive. We had at least 15 other startups pitch the same thing to us that week (2021). No secret sauce. At least their stock price is up now, so that’s good for the Google guy. [Founder David Girourard]. - Tech analyst from a large bank 

“I have an undergrad computer science degree, and what they showed up as AI I was doing in freshman year python classes. And that class barely taught you how to code.” - Financial analyst 

“I think they just scrape software? You can use AI and ML to data scrape, but I’m not sure how that plays into their loan platform. Something like 80% of its loans are immediately approved by software. That doesn’t seem like a good thing.”

In typical Silicon Valley use of meaningless jargon, Upstart talks a lot about trying to democratize access to credit for those who can’t get it elsewhere. And while the obvious issues of adverse selection inherent in targeting that customer base.

“Upstart (NASDAQ: UPST) is the leading AI lending marketplace, connecting millions of consumers to 100 banks and credit unions that leverage Upstart’s AI models and cloud applications to deliver superior credit products. With Upstart AI, lenders can approve more borrowers at lower rates across races, ages, and genders, while delivering the exceptional digital-first experience customers demand. More than 80% of borrowers are approved instantly, with zero documentation to upload. (Narrators Voice: That Is Not A Good Thing)”

Upstart claims on its website: 

And in its investor presentation, Upstart specifically claims it is closing the racial wealth gap. 

Yet, according to an industry watchdog (The Student Borrower Protection Center), Upstart penalized borrowers from a number of minority groups:

Upstart’s Two Biggest Customers (two janky banks with a total of four branches), Representing 73% of Revenue, Have Massive Regulatory Issues 

Upstart only names two approved loan originators in its SEC filings: Cross River Bank and FinWise Bank. While it has over 100 bank partners, we believe these two are integral to Upstart’s business model, and we believe both have massive issues.

Cross River Bank: 51% of Loans, 45% of Revenue In 2022; That Number Will Go Down 

Let’s start with Cross River Bank, Upstart’s largest loan originator and largest source of revenue. If you have followed fintechs, you are probably familiar with Cross River Bank. For a non-publicly traded bank, it has become one of the most important banks in the fintech industry. 

An article by Nathan Vardi and Antoine Gara in Forbes from 2019 discussed Cross River Bank’s model. 

“Gade is being modest about Cross River’s role in the fintech revolution. State-chartered banks like his have the regulatory and compliance framework in place and the lending licenses necessary to originate loans. Most fintechs do not and thus rely on banks for funding. It’s the industry’s dirty little secret. Once you get beyond the slick iPhone apps and inflated tales of big-data mining and AI-generated lending decisions, you realize that many fintechs are nothing more than aggressive lending outfits for little-known FDIC-insured banks.”

Cross River Bank has been a partner for some of the most spectacular failures in the lending space over the last several years: OnDeck Capital, GreenSky, Funding Circle, and GreenBox POS.

To those who have followed fintech, Cross River Bank is well known as a partner to numerous sketchy companies. 

From Upstart’s SEC filings: 

“Cross River Bank, or CRB, a New Jersey-chartered community bank, originates a majority of the loans on our platform. In the six months ended June 30, 2022 and 2023, CRB originated 52% and 41%, respectively, of the Transaction Volume, Number of Loans. CRB also accounts for a large portion of our revenues. In the six months ended June 30, 2022 and 2023, fees received from CRB accounted for 48% and 31%, respectively, of our total revenue.”

And then: 

“CRB retains a proportion of the loans they originate on their own balance sheet, and sells the remainder of the loans to us, which we in turn sell to institutional investors, sell to our warehouse trust special purpose entities or retain on our balance sheet. 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 originate and/or retain on its balance sheet. We or CRB may terminate our arrangement immediately upon a material breach by the other party 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 judgment 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 lending partners on our platform or if CRB or one of our other lending 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.”

Cross River Bank Gets A Cease-And-Desist Order, A Precursor To Being Shut Down? 

In March, Cross River Bank was hit with a cease-and-desist order by the FDIC, which required Cross River Bank to increase supervision of loans. We think this event, while acknowledged by the sell-side, remains misunderstood by the market. 

A FDIC cease-and-desist order from the FDIC indicates that a banking organization or institution is engaging in unsafe, unsound, or illegal practices. We looked at each of the 23 banks served with a cease-and-desist before failure from June 2013 to July 2023. We focussed on banks which failed due to bad or toxic loans or poor credit decisions, the same kind of accusations levelled at Cross River Bank. 

We looked at 23 cease-and-desist letters for similar reasons and found that, on average, it took 15 months between a cease-and-desist letter and the bank being terminated. It has only been five months since Cross River Banked received its cease-and-desist, which required Cross River Bank to increase supervision of loans. 

We don’t think you need to bet on Cross River Bank being shut down for shorting Upstart to work. You simply need what has started to happen to continue to happen: increased regulatory oversight curtailing Cross River Bank’s activity. This has already begun to happen, and we think that will only increase. 

Memories are short, and the bank failures of March and April are already well out of memory. But the consequences are not yet over – the companies that took on risk after the FTX blow-up are now exposed to Coinbase and Binance risk. Cross River Bank has ties to Binance, as revealed after the SEC order freezing Binance US assets. The order included a list of Binance US’s trading partners, which included Cross River Bank in addition to Silicon Valley Bank and Silvergate. 

We think smoke is billowing out of Cross River Bank’s Fort Lee, New Jersey headquarters, and it could take Upstart down with it.

Upstart’s Second Biggest Customer Is Also Facing Potential Regulatory Heat 

FinWise Bank is Upstart’s second-largest bank partner. We believe that in 2022, Finwise accounted for 36% of loans originated and 28% of Upstart’s total revenue. FinWise has partnered with some of the sketchiest lenders we have ever encountered. 

FinWise partners, including Opportunity Financial, Elevate Credit, and American First Financial, face class-action lawsuits for violating lending laws. In one case, a partner was charged with facilitating APRs of between 99% and 251%. 

In March, the National Consumer Law Center (NCLC) and nine other consumer watchdog firms sent a letter to the FDIC over FinWise’s “abusive and predatory” lending practices. The NCLC letter called on the FDIC to downgrade FinWise’s CRA rating. The lower a bank’s CRA rating, the higher the level of regulator scrutiny. 

FinWise is a “rent-a-bank” for various “fintechs, " allowing lenders to sidestep state-regulated interest rate caps. The NCLC says that “FinWise helps several non-bank lenders make predatory loans at rates up to 160% APR that they cannot legally make directly. The loans that FinWise facilitates are not only usurious; they also pose a host of other consumer protection problems and potential legal violations.” 

FinWise was responsible for 36% of loan volume and 28% of total revenue in 2022. 

In Q2 2022, Upstart addressed some of the challenges it faced last year, suggesting that it saw partners pull back due to higher loss aversion from its partners. 

“Given the strength of our model, our strong credit performance, and our conservative calibration to the current economic environment, why have some of our lenders and institutional investors paused or reduced their originations? (To be clear, these lenders and investors have not canceled their agreements with Upstart; but rather have paused or reduced their monthly loan volumes. In short, we’ve seen a greater increase in loss aversion over the past quarter than we expected. Given the unusual uncertainty in the market, our partners are understandably far more worried about potential losses than motivated by potential gains. As a result, some of them have paused or reduced their originations in unsecured lending, which has limited our ability to grow.” - Upstart in Q2 2022

How Upstart Makes (Loses) Money

We view Upstart as a marketing services company. We think it’s effectively an outsourced credit decisioning engine for two crummy banks that have a total of four branches.

Upstart is a classic rent-a-customer company trying to take a small piece of a large transaction in a large total addressable market (TAM). Remember how different the financial markets were in the second half of 2020 and 2021. You could go on CNBC and pitch Upstart as a long and not even know what it did. The pandemic stimulus led to a strong consumer, and Upstart put the pedal to the metal. 

In 2021 and 2022, it enabled the origination of up to $18 billion in loans (annualized) per quarter. With a conversion rate of 13% in Q2 2022, the company and its partners made a whopping $98 billion (annualized) in offers of largely unsecured personal loans. 

That is a MASSIVE number. Consider American Express (AXP), Capital One (COF), and white-label credit card provider Synchrony Financial (SYF). These firms have outstanding card loans of $115 billion, $139 billion, and $92 billion, respectively. 

In Q2 2022, $3.3B in loans were originated through the Upstart platform at $10,202 apiece on 321,138 loans. For doing so, the company received fees of $212M, or 6.5% of the loans originated. That’s the company’s biggest revenue line and it’s predicated on its supposedly superior AI credit decisioning engine.

However, things didn’t go as planned as credit losses subsequently soured, and its partner banks’ appetite for loans apparently waned or were constrained involuntarily.

From this point, basically, everything has gone completely off the rails for Upstart. In Q2 2023 orginiations declined 73%, falling to $1.2 billion. Its vig for originating said loans rose to 7.8% of loan balances originated, or $78 million. 

The majority of its customers come in through the Credit Karma platform, a site where many people worried about their credit score go to check on it. This source of supply smacks of adverse selection (and more on that relationship in a bit). While there, they are offered credit products; Upstart then passes the origination off to mainly two partner banks, who pay the $500 to $1,000 per loan bounty to Upstart. 

This is certainly not highly recurring fee revenue, as it’s paid on the front end of the customer interaction on each loan, not to be repeated unless that borrower comes back for more loans. 

The second largest piece of revenue is “Servicing and other fees” of $38M. This is recurring revenue, with loan maturities generally in the 40-50 month range. Servicing loan pools generates revenue of about 1% of loan balances in this industry, implying Upstart serviced a jaw-dropping $14B+ of loan pools in Q2 2023. That’s 25x the company’s tangible equity, by the way.

We can see this in the company’s disclosure of its maximum loan repurchase liability of $13.8B. We reference tangible equity here because this entire amount is a contingent liability that would be triggered by errors of representations & warranties, fraud, or other events that cause loan performance to deviate from expectations.

Servicing income thus represents 28% of revenue, and total fee revenue equates to 106% of total revenue. That’s higher than 100% because there are negative lines below this in the overall revenue line.

Interest income on securitization residuals and loans represents 25% of revenue, and interest expense represents (3%) of revenue. That leaves 28 points in a catch-all line titled Fair Value and Other Adjustments. This line is super squishy and opaque and appears to be a dumping ground for items that would appear explicitly in competitors’ income statements and other disclosures.

This is the line where all sorts of assumptions appear, and they can make or break the company’s profitability. Profitability is very much subject to accounting choices and estimations made at the time of creating loans. That’s what this company does – it makes lots of estimates, and that determines their earnings. However, those estimates are subject to revisions down the line as the loans age.

For FY 2020 - Q1 2022, Upstart reported $180 million in cumulative net income while acquiring a cumulative $15.2B in loans and selling $14.6B of loans. That’s net income of 1.2% of cumulative loan production or sales. That’s a pretty thin margin of error in a black box business model, which this is (most spread-based financial services companies are, but disclosures can vary radically across the sector)..

Since that time, the company acquired $5.9B in loans and sold $5B, generating a cumulative net deficit of $294M. That’s because credit losses on loans sold into securitization vehicles were worse than expected when the loans were underwritten, driving $153M in valuation adjustments to its interests in securitizations. On top of that, the company has generated losses on the sale of loans, to the tune of $79 million.

The valuation adjustments arising from net charge-offs and other entries have ranged from 15% to an eye-watering 38% of consolidated loans (annualized basis) from Q2 2022 through Q2 2023. In other words, “Oops, our original underwriting was not as good as we thought.”

Let’s just take one securitization – the 2022 ST1 pool. Upon inception of this pool, credit rating agency Kroll estimated cumulative losses of 16.75% for a loan portfolio with a weighted average maturity of just over four years. That works out to 4.1% loss rates per year. Within a year of the original offering of these securities, Kroll had revised its cumulative loss estimate to 26%, or 6.4% annually. By August 2023, eight months later, Kroll again increased its cumulative loss estimate to 30%, or 7.4% annually.

In other words, these losses are about 80% worse than originally predicted and are estimated to run far higher than what mature, battle-hardened credit providers generate. For Q2 2023, Capital One reported card net charge-offs of 4.4%, Synchrony Financial reported net charge-offs of 4.8%, and American Express reported card net charge-offs of 2.0%. This comparison is unfair to those companies and most flattering to Upstart, as Upstart originations include auto and student loans, not just unsecured loans/credit card loans.

According to Jefferies research, annualized default rates for Upstart securitized loans have trended upward over the last 18 months, from an average of around 8% to more than 18% in August, 2023.

All of this is very hard to see because the company’s securitizations are mostly or entirely private. The data on Bloomberg is pretty spotty, and Upstart’s reporting is comically thin. We don’t think this is accidental – the data very deeply vitiates Upstart’s narrative that it knows credit and its credit decisioning is better than the dumb old banks.

Unsurprisingly, a number of Upstart securitizations have breached their triggers, which traps cash that Upstart can accrue as earnings, but not put its hands on). That is a distinct sign of a liquidity problem in the wrong capital markets environment.

As far as we can tell, Upstart jams excess spread income* (or negative income) into its “Fair Value and Other Adjustments” revenue line. To be polite, it is remarkable that a company purchasing $8B to $14B of loans (annualized) per quarter does not report a net charge-off rate in its 10-K filings.

* Income generated on securitized loans after taking into account interest paid to buyers of these asset-backed securities pools, after servicing income, and after credit losses (net charge-offs).

Revenue as a percentage of earning assets peaked at 102% in 2021 and has dropped like a stone since, to 60% in 2022 and an average of 35% in H1 2023. Meanwhile, operating expenses as a percentage of revenue (efficiency ratio), even at their best level were 83%, in 2021. They reached a risible 114% in 2022 and a ridiculous 176% on average in H1 2023. For comparison, the average FDIC-insured commercial bank in the US produced a 53% efficiency ratio in Q1 2023.

At its best, this was a 21% ROE company for one year. Last year, ROE was (14%), and in H1 2023, ROE averaged (49%). This is obviously unsustainable. We believe the company is overstaffed in pursuit of an idea that if they just pour more resources into engineering and product development, it’ll hit on the holy grail of superior credit prediction powers at scale. There are a ton of problems with that.

This company, its investors, and analysts use incantations like ‘asset light’, ‘capital-efficient’, ‘AI,’ ‘recurring fee revenue’, and ‘huge TAM’ to reinforce the impression this is really a tech company or a software company that can produce profitable hypergrowth and make the light speed jump to massive scale.

This company is doing very little different from real, fit competitors like Capital One and Chase. This is extremely bank-like in that its assets are essentially a bundle of derivatives that are subordinated to more senior lenders and when it’s servicing unconsolidated assets of $13B.

Sort of sounds like a bank, right? Pretty close, but this is worse. It’s basically a department of a bank. Its organic distribution capabilities have historically represented a minority of its distribution. It sells into wholesale customers’ systems, and it’s clear there’s no credit decisioning magic. Upstart suffers from the same origin story conceit of so much of Silicon Valley and fintech: That all incumbents are idiots, hampered by ossified structures and cultures, that don’t don’t have the killer move-fast-and-break-things instinct, and are risk averse.

We think that there’s a high probability many Upstart investors have no idea about the armies of computer scientists, capital markets and economics PhDs, and quants within companies like Capital One or JP Morgan Chase. These are not idiot cultures and they’ve been doing AI for longer than Upstart has been around, with better historical databases, organic distribution, incredible capital markets execution, and multiple business lines that can cross-subsidize.

Finally, anyone who has back-tested an algorithm on a very large data set knows (1) You need years of data to train the algorithm  and (2) You need years of out-of-sample periods to test the algorithm’s predictiveness. Also, more data does not necessarily lead to better credit outcomes. We discuss this elsewhere in this document, so we will just bottom-line it: This company’s computer science / capital markets theories and processes are flawed and a bit amateurish.

We don’t see any competitive advantage in the lynchpin area of credit decisioning. This is what the company has sold as its greatest strength, but it has demonstrated this activity is a great weakness at Upstart. The scale mismatch vs huge credit grantors is very clear. Upstart didn’t achieve its intended scale despite making a huge reach. They may continue to take big swings or they may have to downsize to a high degree due to the probably this is a niche business addressing a much smaller TAM than embedded capital markets expectations imply.

We believe Upstart is a cost-of-capital company at best long-term. It has no marketing advantage, no production advantage, and no distribution advantage, in our view. This should call for this to trade at no more than 1-2x its $7 per share of tangible equity in a normal equity markets environment and it could very well trade at a large discount if and when capital markets run into liquidity challenges.

We believe our underwriting is charitable in getting to $1 in GAAP EPS by 2027, with interim losses, and is worth $0 to $10 today.

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