Upstart claims it significantly outperforms FICO, but the market isn’t buying it

The second quarter results of the artificial intelligence (AI) lending platform Reached (UPST 9.62%) were disappointing and included large-scale funding issues. But there was a silver lining in the earnings report.

The company showed updated data that indicates its AI-based loan underwriting algorithms assess risk significantly better than Just Isaacit is (FICO 0.93%) traditional FICO credit scoring. FICO has been one of the primary ways lenders have used to assess the creditworthiness of individual borrowers for quite some time.

This updated data looks impressive, but I’m still a bit skeptical, and I think the market is too.

Banks back down

Upstart’s entire business model is based on the premise that its technology can assess the creditworthiness of loan applicants better than traditional methods such as FICO. This would allow the company to find additional borrowers who have never had access to traditional credit products but who are creditworthy while helping banks increase their loan issuance without increasing their default rates. Based on data provided by Upstart in its second-quarter earnings filings, its models outperform FICO by a wide margin.

Image source: Upstart.

As you can see above, Upstart assesses loan applicants and assigns them a rating, while Fair Isaac’s assessment assigns a numerical rating. What the graph shows is loan seekers who received a high FICO score (deemed more creditworthy) but a low Upstart score (less creditworthy) tended to default on loans at a much higher rate than applicants who have a low FICO score but a high Beginner Level. Likewise, those with a higher Upstart rating didn’t miss much, regardless of the FICO score they received (the default rate ranged from 0.7% to 1.3%). The outperformance is significantly noticeable in the 639 range and below where Upstart A+ ratings have a default rate of 1.3% and E- ratings have a default rate above 14%.

Despite this data indicating that Upstart can better assess creditworthiness, the number of loans issued by banks and credit unions through Upstart’s platform and then retained on their balance sheets really fell in the second quarter of 2022, with total transaction volume down more than 15% from the first quarter. It was surprising. I was under the impression that most banks and credit unions used Upstart to lend largely to prime borrowers and above. For example, one of Upstart’s earliest and oldest banking partners, Clients Bancorp (CUBI 2.31%)disclosed information about its personal loan portfolio in the first quarter of this year and only 1% of the portfolio had a FICO score below 680.

It surprises me that banks and credit unions are pulling back so heavily on original lending to prime buyers and above, because credit quality is still quite good within that group, and given the magnitude of Upstart’s outperformance. Loan demand was also abundant in the second quarter. Maybe the 15% drop represented lending to near-prime and lower borrowers, but I didn’t think banks and credit unions were doing that amount of subprime lending with Upstart because they still tend to be quite conservative.

The bond market has no confidence right now

The other interesting thing about Upstart is that professional investors apparently have very little faith in the company. In August 2021, Upstart issued $575 million of convertible unsecured senior notes due 2026. The notes bore an annual interest rate of 0.25% and converted into stock at $285.26 per share.

Recently, however, due to Upstart’s share price falling and moving away from its conversion price, the bond’s yield to maturity rose to 13.9% on August 10. Bond yields and prices are inversely related, so the bond price has lost value, the yield to maturity has skyrocketed away from the bond’s coupon rate because investors have apparently lost faith in the model. I find it a little hard to believe that professional investors could see Upstart’s credit outperformance, believe it, and still place such a high yield to maturity.

Additionally, current default rates in Upstart securitization vintages (loans that have been issued long enough with enough on-time payments that the risk of default is lower.) issued in 2021 and early 2022 under – are now performing their target gross returns at this point in time. Management said this was largely due to the end of stimulus programs, which is undoubtedly a significant contributor.

But 2021 vintages are faring much worse than pre-pandemic vintages, so it’s hard to say this is just a return to normal. The latest vintages are filled with lending to borrowers lower on the credit spectrum, and they really don’t seem to be performing well at all.

It may still be too early to tell

I’m by no means a data scientist, so I can’t say for sure one way or another if Upstart’s AI underwriting models outperform FICO. What I can say is that the market doesn’t seem to be buying it right now when looking at the actions of banking partners, institutional investors, the bond market and the depressed stock price.

Upstart may end up surpassing FICO, but I still think it’s too early at the moment, and so I don’t know if the data provided by the fintech company is enough to determine the true effectiveness of the company’s technology.

Bram Berkowitz holds positions in Customers Bancorp. The Motley Fool holds positions and recommends Upstart Holdings, Inc. The Motley Fool recommends Fair Isaac. The Motley Fool has a disclosure policy.

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