LendingClub has a huge funding advantage over Upstart

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Although they operate very different business models, digital market banking loan club (CL 10.69%) and the artificial intelligence lender Reached (UPST 16.77%) are market leaders in online personal loans, each having generated at least $10 billion in unsecured personal debt in 2021. While Upstart has generated more loans and will likely continue to do so, LendingClub has a big financing advantage, which will be key as interest rates rise and economic conditions become more difficult. Here’s why.

Deposits and banking partners make the difference

Many fintech companies will take all or most of their loans and sell them to third-party investors such as hedge funds, insurance companies or asset managers, or bundle loans into asset-backed securities (ABS ) for investors who cannot hold the entire loans directly on their balance sheets. Another method is to partner with banks that have their own deposit bases to fund loans and record them on their balance sheets.

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Upstart’s goal is to generate as many loans as possible across the credit spectrum, which is why it tends to generate more loans than LendingClub, which primarily focuses on prime borrowers and at -above. But Upstart also wants to be capital efficient and not hold loans on its balance sheet. In 2021, Upstart’s banking partners retained 16% of Upstart’s originations on its balance sheet, while 80% of loans were purchased by institutional investors.

The problem with this loan funding model is that when interest rates rise as quickly as they have this year due to the Federal Reserve’s desire to control inflation, and the risk of a recession increases dramatically, institutional investors become less willing to take riskier risks. loans, and can demand much higher returns, driving up the price of loans for consumers. Investors are also becoming much less likely to invest in ABS – and ABS issuance has fallen significantly this year compared to 2021.

That’s why it’s much better for deposits to fund loans, because they’re much cheaper for banks than the kind of funding that institutional investors typically have to afford. Also, when the Fed raises rates, there is usually a lag period before banks start having to increase the interest they pay on deposits.

LendingClub decided to become a bank and in early 2021 became one of the first fintechs to obtain a banking charter by acquiring Radius Bank. LendingClub now has $4 billion in deposits and funds ranging from 20% to 25% of its own creations, which it holds on its balance sheet. On his first-quarter earnings call, LendingClub CEO Scott Sanborn said about half of his builds are funded by partner banks, including LendingClub itself, so a much higher percentage high loan LendingClub is funded by low cost deposits only Upstart.

Less dependent on capital markets

After Upstart’s latest results, its stock price fell more than 60%. Believe it or not, it wasn’t because of the results or strictly because the company lowered its guidance. Upstart revealed that as interest rates rose and investors recalculated how much risk they wanted to take on, the company needed to hold a smaller portion of its loans on its balance sheet than it would normally sell to investors in order to fill the gap. Because Upstart’s model is all about making loans and then quickly taking them off the balance sheet, that wasn’t what investors wanted to see.

Additionally, in Upstart’s latest $545.2 million ABS, ratings agency Kroll Bond noted that it expects loss rates to be more than 3% higher than the ABS Upstart released earlier this year, and the rating coupon was higher, reflecting more risk. Since Upstart sells the vast majority of loans to investors and in the capital markets, investors fear that these avenues will dry up in a riskier environment, which would likely force Upstart to slow its growth.

But LendingClub has made a much more concerted effort to be less reliant on capital markets. Not only are half of its loans funded by banks, including LendingClub, but in the company’s latest earnings call, CFO Tom Casey said the company had “deliberately” targeted leveraged investors. lower and less exposure to capital markets specifically to avoid the situation that has unfolded in recent months. LendingClub didn’t do ABS either. LendingClub CEO Scott Sanborn said the number and diversity of loan buyers in its marketplace is now much higher than before the pandemic.

I also find it interesting that one of the reasons Upstart has had to hold loans on its balance sheet is that its platform for buying loans for institutional investors is still largely manual, which slows down the process as institutional investors calculate new yield thresholds as the risk of loan defaults increases. LendingClub has an automated loan auction platform that can achieve market clearing prices on its loans for investors in just days, allowing the company to quickly adapt to new environments. Recently, LendingClub allowed investors on the platform to sell loans directly to each other, which will further increase liquidity in its market.

LendingClub is better prepared for a tough environment

All of these reasons above make LendingClub much more prepared to deal with an intense rate hike environment like the one we find ourselves in now, largely because it has a much better funding model and is much less beholden. to capital markets. Additionally, LendingClub’s automated lending marketplace can effectively adapt to rapid changes in the environment. While Upstart may be able to generate more loan volume, LendingClub can absorb market shocks much more smoothly and should be much more durable during market volatility and a down economy.

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