LendingClub, Upstart downgraded at J.P. Morgan

JP Morgan analyst Reginald L. Smith downgraded Upstart Holdings and LendingClub due to valuation concerns and the current state of the fintech market.

Specifically for Upstart:

• Smith downgraded the stock from Neutral to Underweight

• Raised the price target from $45 to $57

• Noted concerns about the stock's current pricing, which reflects a potential rebound to fiscal 2022 origination levels that may take several quarters to achieve

For LendingClub:

• Downgraded from Overweight to Neutral

• Raised the price target from $14 to $17

• Highlighted shifting investor concerns from loan portfolio credit quality to third-party funding accessibility

Reginald L. Smith noted that 2024 has had two distinct parts. Since mid-September, the value of the fintech sector has grown by more than $65 billion.

This growth was driven by:

• Positive third-quarter 2024 results

• Favorable management commentary

• Two rate cuts

• Anticipation of the U.S. Presidential Election

Looking ahead to fiscal 2025, Smith expects lower benchmark rates and an improved third-party funding environment to potentially spur increased loan origination volumes.

What is the primary investor concern regarding LendingClub Corp’s business model?

According to JP Morgan analyst Reginald L. Smith, investor concerns for LendingClub Corp have shifted from credit portfolio quality to two primary issues:

Third-Party Funding Accessibility

• Investors are now focused on the company's ability to secure external funding

• Concerned about the ease of obtaining third-party financial support

Balance Sheet Expansion

Emphasis on the company's capacity to:

• Expand its balance sheet

• Enhance return on tangible equity (ROTE)

LendingClub's unique marketplace-bank model, which combines fee income from the marketplace with interest income from banking, remains a potential strength. The company continues to leverage opportunities in the personal loan market and maintain a competitive stance despite these investor concerns.

How does the "flywheel effect" contribute to the success of Upstart Holdings?

Upstart's AI-Driven Lending Flywheel Effect benefits from a powerful virtuous cycle where improved data continuously enhances the platform's capabilities:

1. Initial Data Collection

• Gather detailed repayment information

• Track borrower performance across loan cycles

2. Risk and Fraud Detection Improvement

• More repayment data leads to enhanced risk assessment

• AI algorithms become increasingly sophisticated in detecting potential defaults

3. Operational Enhancements

Higher-quality data enables more accurate:

• Approval rates

• Credit risk modeling

• Fraud prevention strategies

4. Performance Outcomes

• Higher approval rates

• Increased transaction volumes

• More precise lending decisions

• Continuous algorithmic refinement

The flywheel creates a self-reinforcing mechanism where each loan cycle provides more data, allowing Upstart to:

• Reduce default risks

• Improve lending precision

• Attract more institutional capital partners

By leveraging AI and machine learning, Upstart transforms raw repayment data into a strategic asset that continuously improves its lending platform's performance.

Trends in Fintech Lending Credit Quality

The trend in credit quality within fintech lending is on the rise, thanks to positive macroeconomic conditions and cutting-edge advancements in risk assessment technologies.

1. Improving Macroeconomic Conditions

Several factors suggest a positive shift in the consumer credit market, bolstering credit quality. These include:

• Receding inflation 

  • Inflationary pressures are easing, contributing to a healthier economic environment.

• Robust employment market

  • The strong job market provides consumers with greater financial stability, reducing the risk of loan defaults.

• Anticipated lower interest rates

  • Projected decreases in interest rates are expected to stimulate borrowing and improve affordability for consumers.

• Increased loan origination volumes

  • Both LendingClub and SoFi have reported substantial year-over-year growth in loan originations, signaling a positive trend in consumer borrowing and confidence in loan repayment.

• Improved third-party funding environment

  • Enhanced access to funding for fintech lenders allows for increased lending activity and improved gain-on-sale margins.

2. Advancements in Risk Assessment Technologies

Fintech lenders are leveraging innovative technologies, particularly AI and machine learning, to enhance their risk assessment capabilities. These advancements contribute to:

• Improved risk and fraud detection

  • AI-powered algorithms analyze vast datasets to identify patterns and assess creditworthiness more accurately, leading to better risk management and a reduction in potential defaults.

• Higher approval rates

  • More precise risk assessment enables lenders to approve loans for a wider range of borrowers while maintaining prudent lending practices.

• Stabilizing credit trend

  • The combination of improved economic conditions and enhanced risk assessment technologies contributes to stabilizing credit trends, reducing the likelihood of significant fluctuations in default rates.

However, despite these positive trends, analysts advise caution, highlighting the need for continued monitoring of credit quality.

Lingering Concerns:

• Default rates remain elevated compared to historical levels. Upstart's UMI suggests default rates are currently 40% higher than historical averages.

• Valuation concerns persist, with analysts suggesting that current valuations may be overly optimistic and not fully reflect potential risks.

Investor Focus Shifting:

• Investor concerns are shifting from the credit quality of loan portfolios to the availability of third-party funding and the ability of fintech lenders to grow their balance sheets and improve return on tangible equity (ROTE).

Alternative business lenders should carefully consider these credit quality trends when making lending decisions. While the improving economic environment and technological advancements provide a favorable backdrop, the persistence of elevated default rates and valuation concerns warrants a cautious and data-driven approach.

Continuous monitoring of credit quality trends and leveraging advanced risk assessment tools will be crucial for mitigating potential risks and capitalizing on opportunities in the evolving fintech lending landscape.

Our Opinion

JP Morgan believes that Upstart's stock price already takes into account a possible return to the 2022 levels of loan originations. This suggests that the market might be facing a problem with stocks being priced too high.

The LendingClub situation highlights a shift in investor concerns from credit quality to third-party funding accessibility. Reliable funding is crucial; even the best underwriting model is ineffective without consistent capital access.

Smith's observation of the $65 billion fintech growth since mid-September highlights four drivers: positive Q3 results, management commentary, rate cuts, and election anticipation. This suggests sentiment may be driving the sector more than fundamentals. Alternative lenders might question whether the optimism is entirely warranted.

This news highlights a key change in the industry, moving from worries about credit quality to focusing on how easy it is to get funding. As the alternative lending market grows, it faces challenges similar to traditional banks. Even with exciting new technologies like AI, having steady funding and managing credit risk are very important. It's a reminder to focus on sustainable business practices rather than just market trends. Although increasing valuations are attractive, Alternative Business Lenders should prioritize how well loans perform, the cost of funding, and how efficiently the business operates.

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