Upstart Lends Money It Doesn't Hold. What Does That Do to the Stock in a Downturn?

Lending is a tricky business. Interest income from payments may look stellar for years, but if just a small portion of these loan recipients stops paying, profits can be wiped away. A peculiar business in the lending "supply chain" is Upstart Holdings (NASDAQ: UPST).

The pandemic-era stock market darling uses artificial intelligence (AI) to price personal and auto loans before selling them to third parties. It is the middleman that tries to run with an asset-light balance sheet compared to banks, mitigating payback risks.

But what happens if the lending markets freeze during a downturn? The answer could get quite scary. Here's why.

Pricing loans for third parties

Upstart is a technology-forward firm that has tried to build and hone AI models for pricing consumer loans. However, instead of acting as a bank itself, a bank will contract with Upstart to price its consumer loans, which Upstart will then try to sell to third parties to hold. As a middleman, Upstart will earn fee revenue for its services.

This seemed like a revolutionary idea that could potentially disrupt the entire loan pricing supply chain, such as the FICO score. Upstart's fee revenue was going vertical as it helped originate more and more loans. However, after the pandemic disruptions ended, Upstart's business went in the wrong direction, where banks realized its AI models were not "magic" and pricing risk much more intelligently.

The real concern was the freezing of Upstart's loan-buying partners, which forced Upstart to begin piling loans onto its balance sheet and take on lending risk. Originations fell, and Upstart was deeply unprofitable for years. To fix these issues, Upstart has sought committed capital partners, secured more loans, such as automotive loans, and trimmed its own costs to operate more efficiently. Over the last 12 months, it has now begun to generate a profit again.

Image source: Getty Images.

Is Upstart stock a buy?

During the last lending downturn in 2022 and 2023, Upstart faced major risks as fee revenue dried up and it couldn't offload loans to third parties. In a future downturn, the business looks much better prepared to weather any storm that shows up.

Right now, Upstart shares are in a 94% drawdown, as investors remain sour on the business's prospects after the past few years. The company is only slightly profitable today and has never proven it can generate steady profits for shareholders. However, if you believe the profit recovery will continue, Upstart may do better over the market cycle because of the committed financing deals it has secured.

Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Upstart. The Motley Fool has a disclosure policy.