Caution with Judo Bank still Warranted for Conservative Investors

Judo Bank recently obtained a rating of BBB-, the lowest investment-grade rating from S&P. S&P had applied a one-notch negative adjustment to reflect risks from Judo’s short track record in terms of both lending and profitability, implying the rating would have been BBB otherwise. Judo Bank only received its full banking license in April 2019.  It recorded a net loss of $50.8 million in FY20 (loss of $28.0 million in FY19).  For FY22, Judo’s management is forecasting the bank to post a net profit of $5.2 million, up from a forecast net loss of $5 million in FY21.  According to S&P’s Research Report dated 15 September 2021, “Judo Bank has yet to prove it will be able to sustain its business growth and retain its clients through a full economic cycle or periods of more aggressive competitive pressures while continuing to improve its profitability.”

Despite its limited profitability, Judo Bank appears to be well capitalised.  Since Judo’s creation in 2016, the bank has raised $1.2 billion in equity from investors, with the latest equity raising of $124 million completed in June 2021.  Capital raising is supporting Judo’s continued loan growth.  Judo’s loan book is $4 billion (which has more than doubled since the start of the pandemic), while its deposit book is $2.8 billion as at September 2021.

According to S&P “there remains ongoing uncertainty around Judo Bank’s credit losses, both as its portfolio seasons and as the COVID-19 pandemic progresses given the greater sensitivity of SMEs to operating conditions.”  Judo Bank specialises in providing loans to small and medium-sized businesses (SMEs) with Judo’s lending portfolio to SMEs increasing 84% over the period of March to December 2020.  Total business loans represent 78% of Judo’s total loans as at September 2021.  Judo offers loans of up to $20 million to SMEs, with an average loan size of $2.5 million. 

Judo Bank’s S&P credit rating will allow the bank to further grow its deposit portfolio further as a credit rating will facilitate access to a wider investor base who may only have mandates to invest in rated product.  Judo is also preparing to be listed on the Australian stock exchange in early November 2021, which will provide increased transparency for debt as well as equity investors.

Amicus shares S&P’s concerns regarding Judo’s lack of actual profitability and reliance on its internal forecasts that it will be profitable by 2022.  Further, like S&P, we see considerable risk in forecasting future loan losses for SME’s given no established track record from the bank or comparables to see from actual results how aggressive or effective its lending policies are in practice. We also note unlike nearly every other ADI in Australia, Judo’s loan book is comprised predominantly of SME loans as opposed to residential mortgages.  Historically, SME loans have had much higher default rates and those default rates have been much more volatile depending on economic conditions as compared with residential mortgages.  This has been compensated for through higher margins paid on these loans and while this may help Judo’s profitability it is only if default rates are very low the additional margin will provide a material buffer to absorb additional losses in a downturn.

While we recognise house prices have risen over the past year and this will provide a greater buffer to those ADI’s whose balance sheets are exposed to residential mortgages, the same cannot necessarily be said for Judo as it is yet to be seen how businesses will emerge from the current lockdowns when government support is withdrawn; although we accept that many of its smaller loans to SME’s may be secured on the residential property of the business owner.

We also question the normal rationale of diversification for investors in the case of Judo.  For a portfolio of investments spread across a wide range of ADIs, diversification limits losses in the case of a single ADI having poor lending practices, controls, management, fraud, etc.  However there is no protection against a system wide downturn in residential mortgages.  In an extreme where there was such a severe downturn, investors would be reliant on the government to bail out all the banks.  Adding Judo to such a portfolio at say a 5% exposure does not provide meaningful protection because if SMEs were not affected by a severe downturn in residential mortgages (unlikely anyway) it simply means there will be a problem with 95% of the investor’s portfolio rather than 100%.

In contrast if SMEs experience a downturn and residential mortgages are not affected, the investor then has a problem with the 5% of his portfolio exposed to Judo as opposed to 0% if the investor limited his exposure to other ADIs who invest largely (or solely) in residential mortgages.  Hence it could be argued adding Judo to an investment portfolio comprised of other ADIs all exposed predominantly to residential mortgages simply adds an additional risk to the overall portfolio.

The above is an example of the research Amicus undertakes on behalf of our clients and our prudent approach to investing. Helping conservative fixed income clients is our core expertise. Please feel free to contact Amicus if you feel your organisation could benefit from any of Amicus’ services.

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