On Wednesday, May 17, the Dow and S&P 500 took a nose dive, recording their worst day since last September as the political side-show in Washington D.C. threatened the market’s eight-year bull run.

[ad#Google Adsense 336×280-IA]While stocks have recovered from the selloff, all eyes are still on Washington for risks to the market.

But political risk isn’t the biggest hurdle to stock gains.

The biggest risk, one that has been building for more than a year, is now spreading and could be about to put the brakes on consumer spending and the entire economy.

Real evidence is mounting that a consumer credit crisis is brewing in America.

It’s an eerie reminder of the mortgage crisis and could turn out to be just as spectacular when it all comes crashing down.

The Crisis In Auto Loans Is Spilling Into Consumer Loans

The crisis has been building in auto loans for over a year, as rock-bottom interest rates sent sales of cars to consecutive annual records. When car prices started to increase, lenders relaxed standards and nearly doubled the amount of time people could pay on the loan. The total amount of auto loans outstanding has jumped 50% since 2010.

But cracks started to show in the market for auto financing last year as defaults surged. Lenders are now tightening requirements for auto loans with new loans to subprime borrowers falling to a two-year low in the first quarter. At the same time, a growing number of auto loans are defaulting, with the number of loans 90 days late or more currently sitting at a four-year high.

The growing number of defaults may be just the tip of the iceberg. A recent report by Point Predictive that estimates borrower fraud is approaching levels seen before the mortgage crisis and could cost lenders as much as $6 billion this year.

The firm noted that fraudulent applications included falsified income documents and sometimes collusion with the dealers themselves. That should be a warning to investors, and not just for the auto loan market.

UBS recently cited a 2015 paper authored by economists at George Washington University and other institutions that found borrowers have become more skilled at gaming their credit scores ahead of loan applications over the last decade.

This means that underwriting models that gauge a person’s ability to pay partly from their credit score may no longer be a good indicator of creditworthiness.

That could mean big problems over the next few years as lending tightens and borrowers aren’t able to get new money to keep ahead of payments on loans they couldn’t afford in the first place.

Traditional lenders are responding to the potential credit crisis by tightening standards for new loans. The Federal Reserve reports that 8.3% of banks tightened standards for consumer loans and credit cards in January, the third consecutive month of tightening. More than 11% of banks tightened standards for auto loans.

Fintech consumer loan companies are feeling the pressure as well.

Bloomberg reports that student and personal loan startup Earnest Inc. has been unsuccessful in raising funds and is seeking a buyer. The largest peer-to-peer lender Lending Club (NYSE: LC) has seen loan volume slip in each of the last three quarters, reporting a 29% drop in first-quarter loan originations versus the same period 2016. Anecdotally, I have seen loan volume drop to nearly half its previous-year average on websites I own that collect commissions on personal loan originations.

The Next Shoe To Drop In The Consumer Credit Crisis

It would be easy to call out companies that originate auto loans or those in the peer-to-peer lending space, but those stocks have already taken a beating on the change in the credit environment. Lender CarMax (NYSE: KMX) has fallen 13% from its February high and Lending Club is struggling to attract investors even after dropping nearly 80% from its December 2014 IPO price.

The next selloff targets in the coming loan crisis may be further down the line in consumer spending: The companies selling products that are heavily financed.

Spending on home improvement surged over the last several years on easier access to credit and rising home prices. A 2015 survey of 1,300 homeowners by SunTrust Bank found significant increases in homeowners planning to pay for improvement projects with credit versus savings. The percentage of respondents planning to pay for improvements with credit jumped to 46% from just 27% the year before.

Home improvement retailer Home Depot (NYSE: HD) has seen its shares surge 216% over the last five years and now trades for 24 times trailing earnings.

Home Depot and competitor Lowe’s (NYSE: LOW) have both made large acquisitions recently to compete in the maintenance, repair, and operations market for property managers. The combination of integration hurdles, increased competition in the space and a tightening credit environment adds a lot of operational risk to the shares.

Whirlpool Corporation (NYSE: WHR) has seen its shares nearly triple over the last five years but may see financing come under pressure for its high-ticket appliances.

Receivables, the money the company is still waiting to collect from credit sales, has ballooned to 37% of current assets for three consecutive years from 28% in 2013. Tightening credit standards could slow sales and cause the company to struggle with available cash flows.

Consumer lending and credit card issuers like Discover Financial Services (NYSE: DFS) may see defaults rise and balance payments slow if consumers aren’t able to get access to debt consolidation loans. Discover’s exposure to student debt, personal loans, and credit cards puts it in the middle of several evolving credit crises.

Discover will likely see a slowdown in lending on a tighter credit environment, but the Federal Reserve’s plan to shrink its balance sheet starting this year or next could further weigh on deposit growth by removing a key buyer of Discover’s mortgage loans.

Risks To Consider: A strong employment picture and rising wages may be able to delay the consumer debt crisis and prop up companies in the space.

Action To Take: Avoid or sell off your positions in companies that rely on a high amount of financing for their products including autos, home improvement, credit cards, and appliances.

— Joseph Hogue

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Source: Street Authority