(FORTUNE Magazine) – To CEO Arthur Martinez and his shareholders, "the softer side of Sears" is no longer just an uplifting ad ditty promoting his new and improved company. These days, Sears' "softer side" evokes something awful--the mushy condition of the company's credit card business. Bad-debt write-offs are surging--at a time, oddly, when most of Sears' major credit card rivals are stemming their losses.

Credit is crucial to Sears: The business generates almost half of corporate profits. Yet a barrage of problems is threatening to undo Martinez's remarkable turnaround of the company. Credit chief Steven Goldstein resigned in December. Sears' overly aggressive debt-collection practices are the target of a Justice Department investigation. Sears' just-announced year-end results show profits down 6.6%. The stock has dropped 30% since last summer. And Martinez isn't very optimistic about 1998.

Although Sears Credit seems to have soured suddenly, the seeds of woe were planted a few years ago. Soon after Jane Thompson, Goldstein's predecessor, took charge of Sears Credit in 1993, she doubled the rate at which Sears was issuing new cards, to more than six million a year. Martinez says Sears did not reduce its credit standards, but too many of those new card customers chose personal bankruptcy over paying their bills.

"I'm a bit old-fashioned. I hold the fundamental belief that if you buy merchandise, you should pay for it," says Martinez. U.S. bankruptcies have nearly tripled in the past decade to an all-time high.

When Goldstein, a Martinez recruit from American Express, took over Sears Credit in April 1996 (Thompson moved over to run Sears' home-repair business), he worried about the bankruptcy boom but figured that Sears had the problem under control. "Our delinquencies were growing, but gradually and along with the industry," Goldstein recalls. The new credit boss did some smart things--he expanded Sears' collection department and invested in technology, hoping to bring the level of Sears' risk-management systems up to that of sophisticated rivals like Citicorp. Seeking to double the size of Sears Credit in five years, however, he chased new accounts as zealously as his predecessor.

Meanwhile, other card companies were cutting back. Steve Kernkraut, a Bear Stearns analyst and ex-president of J.C. Penney Credit Services, believes that as a result, Sears attracted too many high-risk customers. "Sears was being very generous when everyone else was tightening credit standards," he says.

Big trouble broke last spring. Some cardholders in Massachusetts sued Sears over the aggressive methods it used to persuade bankrupt customers to pay their balances. The infractions seemed minor, but the cost of Sears' violations ended up being major: a $475 million pretax charge to settle lawsuits that had spread to 50 states. The scandal blind-sided Martinez, who says neither he nor Goldstein had known that Sears' collectors were acting improperly. "The practices were more deeply rooted and longer term than I could have imagined," the CEO says.

Then, last summer, bad-debt charge-offs (for uncollectible accounts that are more than 209 days past due) shot up--to over 8% of receivables, twice the level of two years earlier. According to one source, Goldstein said he had urged Martinez to disclose the fact that Sears Credit's problems were more serious than anyone was acknowledging. Goldstein tells FORTUNE that he and Martinez didn't clash, though he was terribly frustrated that he couldn't properly analyze the delinquent accounts. "We had teams of people working day and night," he says. But the computer systems still weren't state of the art, so "analysis that should have taken hours took weeks."

When Goldstein left, people in the credit industry speculated that heads were rolling at Sears--and that Goldstein's was one of them. "That's absolutely false," says Martinez. Goldstein concurs: "The timing of my leaving looks funny, but there's nothing sinister behind it."

What's the remedy for Sears Credit? "There's no silver-bullet answer," Martinez says. Some impatient investors wonder whether he might sell the credit business. No way. Despite all the problems, credit remains wonderfully profitable for Sears--contributing an estimated $500 million to the company's $1.2 billion net income last year--and it is the company's vital tool for selling big-ticket items like appliances and TVs.

Rather than taking radical action, Martinez and his new credit boss, former chief financial officer Alan Lacy, will surgically repair the business. New-account growth will be moderate this year. To comply with bankruptcy law, Sears will be more cautious in its collection methods too. Once the Justice Department completes its investigation--by spring, Martinez hopes--he will discipline some collection managers. "There will be people who lose their jobs," he says.

The CEO is braced for 1998. "Credit earnings will be under enormous pressure," he says, noting that his goal of double-digit earnings growth will be nearly impossible to reach.

One piece of good news: Sears stock is down so low that many Wall Street analysts recommend it. They know that Martinez can fix a battered business--he did it before. It's time for him to show his tougher side again.

--Patricia Sellers