(FORTUNE Magazine) – For millions of Americans, the first big financial decision in life is whether to take on a student loan. Student loans are debt, of course, but they represent something different than credit card debt or a car loan: They are part of a quest for a better future. And they can have lifelong consequences, both good and bad, because for the unwise or the plain unlucky, a student loan can become an inescapable burden. It can almost never be expunged in bankruptcy, and the Supreme Court just ruled that even Social Security income can be garnisheed to pay for defaulted student debt.

The giant of the student loan industry is the Student Loan Marketing Association, better known by its friendly-sounding nickname, Sallie Mae. Many people think that Sallie Mae, like Fannie Mae and Freddie Mac, is sponsored by the U.S. government. And until recently it was. But at the end of 2004, Sallie became an independent, publicly traded company, completing a process begun in 1996. It is now radically different than it was even five years ago--an aggressive, highly profitable lender and a stock market superstar. Since 1995 its stock has returned over 1,900%, trouncing the S&P 500's 228% gain. Today Sallie's stock sells for 22 times earnings and almost ten times tangible book value, "an almost unheard-of valuation for a financial institution," as a Criterion Research report noted.

Sallie's dividend has risen at an average annual clip of 18% over the past ten years. And thanks to hefty helpings of stock options, Sallie's top executives have earned fortunes. From 1999 to 2004, just-retired CEO Al Lord --now the lead investor in a group trying to purchase the Washington Nationals --received total compensation of $225 million. New CEO Thomas "Tim" Fitzpatrick made $145 million over the same period.

To produce those sorts of numbers, a company usually has to be obsessed with the bottom line, and Sallie is certainly that (a big chunk of its executives' bonuses is based on Sallie's profits). As good as that may be for shareholders, a growing number of critics contend that those profits are coming at the expense of Sallie's other constituents: students and taxpayers. "Sallie advocates policies we believe are frequently contrary to the interest of students," says Luke Swarthout, a higher-education advisor to the U.S. Public Interest Research Groups. He charges that Sallie used its political clout to shape new legislation that will increase the cost of student loans. Ira Rheingold, executive director of the National Association of Consumer Advocates, decries Sallie's growing presence in the ugly business of collecting on defaulted debt. Pennsylvania state representative Doug Reichley alleges that Sallie is engaging in "predatory lending." Indeed, Sallie uses high interest rates and fees to charge students as much as 28% annual interest on loans. As a result, some have seen their school-loan debt balloon into six-figure delinquencies that they can't hope to pay when the collection agency (which nowadays may be owned by Sallie) comes calling.

"Sallie Mae's practices are in the best interests of students, schools, and taxpayers," a spokesman says. "We were created 34 years ago to provide access to higher education for Americans, and that's still the business we're in. No one wins if a student borrower is unable to repay his or her loans."

You could also argue that student loans are simply a business, like computers or laundry detergent--or maybe health care--and that Sallie's sole responsibility is to deliver results for its shareholders. But lately there are even some doubts about Sallie's ability to do that, given the increased risks it is taking to sustain its high profits. Two Wall Street analysts actually rate Sallie's stock underperform. Many investors buy the stock because they still see it as a safe, government-backed company. They may be in for a surprise.

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Sallie's creation was one of a series of steps that the U.S. government took to back higher education with taxpayer dollars. In 1965 the government passed the Higher Education Act, which created the Federal Family Education Loan Program, or FFELP. Under the program, a bank that makes a loan to a student--who would otherwise be a credit risk by virtue of being a student-- will be reimbursed by a guaranty agency if the loan defaults. If the guaranty agency fails to collect on the loan, the Department of Education--in other words, taxpayers--will ultimately stand behind it.

In addition, the government guarantees lenders a certain level of profit on FFELP loans. Their interest rate is set by the government, not the market, and is currently capped at 8.25%. If students are paying less than a certain rate--right now, the cost of commercial paper (just over 4%) plus 2.34%--then the government pays the lender the difference. This, however, is a one-way street. If students are paying more than that, the lender gets to keep the extra profits. The argument is that without these guarantees, students would have to pay far more for their loans. But you can also see why Barmak Nassirian, the associate executive director of the American Association of Collegiate Registrars and Admissions Officers, says, "The public takes all the risk, and private companies make all the money."

In 1972 the government decided that it could increase the amount of capital available for student loans by creating Sallie Mae. Sallie's purpose was to use low-cost debt guaranteed by the U.S. government to buy existing student loans from banks, thereby allowing banks to make more loans; Sallie makes its money on the spread between the cost of its funds and what students pay and has the same guarantees that the original lender did. For most of its existence, Sallie was limited by statute to a narrow role in the student loan industry. It could market and service loans, as well as hold existing loans, but it couldn't originate its own loans.

By the early 1990s complaints were mounting that the banks making student loans were reaping large profits on taxpayer money. The Clinton administration pushed through a plan under which the Department of Education would lend money to students directly, bypassing private lenders, guaranty agencies--and Sallie Mae. Sallie's stock lost over half its value from early 1993 to late 1994. Direct lending "called into question our existence," says Marianne Keler, Sallie's executive VP.

Sallie decided that its only chance for survival lay in breaking away from the government. In 1996, Congress authorized Sallie's privatization. That meant the government would no longer guarantee Sallie's debt, but it also meant that Sallie would no longer face any restrictions on its business.

In the intervening years, Sallie has slowly replaced its government-backed debt with market-priced money. But Sallie still earns its money with the help of taxpayer dollars, because 87% of its portfolio consists of FFELP loans. Indeed, on a recent conference call Charles Gabriel, an analyst at Prudential, referred to such loans as the "lifeblood of Sallie Mae."

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Under CEO Lord, Sallie's growth was nothing short of phenomenal. Net income more than quadrupled between 2000 and 2004, from $465 million to $1.9 billion. Citigroup analyst Brad Ball, who rates the stock a buy, calls the company a growth machine. Today Sallie, which earns a return on equity of about 35%, is one of the most profitable financial services firms in the world, and it has told the Street that it will continue to grow its earnings at a 15% to 20% annual clip. Gabriel described Sallie's business as "high-growth, profitable, recession-proof, and almost 100% federally guaranteed."

One reason for Sallie's growth is that during the past decade student loans have been among the fastest-growing areas of financial services because of the rapidly escalating cost of a college education. In addition, Sallie has expanded its business to encompass the whole spectrum of student lending, buying companies that make loans, running guaranty agencies, and purchasing debt-collection firms. (Fee-based revenue now accounts for roughly 30% of Sallie's business.) And while Sallie was always a large owner of student loans, today it is gargantuan--it owns about four times the amount of FFELP loans as its nearest competitor. Sallie has $81.6 billion of student loans on its balance sheet and another $39 billion in trusts off its balance sheet. (Sallie has sold the off-balance-sheet loans to third-party investors via securitizations, but it still manages and services the loans.) "We do not view the company as having a serious competitive threat," wrote Wachovia analyst Joel Houck in a recent report.

Perhaps the biggest benefit of privatization for Sallie Mae has been the freedom to make its own loans. It has eclipsed many of the nation's banks to become one of the top originators of new student loans--both FFELP loans and something known as "private credit" loans. Those are loans not backed by government guarantees that students use as supplements to or substitutes for FFELP loans--if, for example, they are maxed out on government-backed loans or if they attend a school that isn't eligible for the loans. Such loans have "skyrocketed" in the past few years, according to the College Board, as the cost of college has soared and the availability of FFELP loans hasn't kept pace. And because the government is not involved, they have no interest rate cap.

Sallie rolled out its first private credit offering in 1996 and now has an estimated third of the market. Such loans currently represent 13%, or $15.4 billion, of Sallie's portfolio. But private credits are more important to Sallie than that 13% figure might suggest. Because Sallie can charge whatever interest rate the market will bear, the spread on such loans is higher than on FFELP loans--in fact, in the most recent quarter, Sallie earned a spread of 4.75% on its private credits, compared with a spread of just 1.31% on its FFELP loans. And Sallie's private credits are growing much faster than its government-backed loans. In the same quarter, private credits grew 70%, vs. 8% for FFELP loans.

The explosion of that business is an important reason that Wall Street loves Sallie; another is the company's success in beating back the government's direct-lending program. Direct lending soared from nothing to a peak of 34% market share in 1997, but today it accounts for under 25% of the student-loan market. This is despite the fact that recently the Congressional Budget Office, the Office of Management and Budget, and the Government Accountability Office have all said that direct lending costs taxpayers less money. (A lending industry group denies this and says that the government's accounting is full of errors.)

Sallie says that direct lending has lost share because colleges and universities, which choose whether they will offer their students FFELP loans or direct lending, simply like FFELP loans better. But there's another possible factor: Sallie's roughly 400-person salesforce, the industry's largest, which actively markets the company's loans to colleges and universities.

Under the Higher Education Act, it is illegal for a lender to offer "inducements" to a school for its business. But the law is somewhat vague as to what constitutes an inducement. For instance, one common practice is something called a school-as-lender program, under which universities make their own loans to graduate students and then may sell the debt to a lender like Sallie for a premium that can be anywhere from 2% to 6% of the total value of the loans. In exchange the university often agrees to use that lender, not the government's direct-loan program, for its undergraduates. Another bargaining chip is private credit, something that the government can't provide. "Most lenders will offer better terms on private credit if they have a complete relationship with the school," says Sallie Mae's Keler.

These practices walk a fine line. In 2003 the Department of Education's Office of the Inspector General received anonymous allegations that Sallie was offering illegal inducements. It investigated two schools and found that at one of them Sallie had negotiated preferred-lender status in exchange for providing a specific amount of private credit loans. The Inspector General didn't conclude that the law was violated but did recommend that such practices be addressed through "statutory or regulatory changes." The Department of Education has not taken any action. Sallie says that the lending industry has developed guidelines with schools on inducements.

In meeting the competitive threat of direct lending, Sallie has been no less adept at wielding its clout on Capitol Hill. This year Sallie has had to face a major legislative challenge that could have altered the structure of student lending: the pending reauthorization of the Higher Education Act, which comes at a time when there is a congressional mandate to trim billions from student-loan budgets. A bipartisan effort would have reinvigorated direct lending by awarding extra grant money to schools that choose the program that is cheapest for taxpayers. It failed. In late November the House passed an HEA reauthorization bill that does cut the subsidies to lenders but gets much of its savings by raising the costs of loans to students. That bill still needs to be reconciled with a Senate version, but John Boehner (R-Ohio), chairman of the House Education Committee, told lenders in December that he thought they would be happy with the final results. "Know that I have all of you in my two trusted hands," he said.

Sallie, a creature of Washington, is of course no stranger to its ways. At a 2004 dinner that a company lobbyist threw for Boehner, 34 Sallie executives wrote checks for his political action committee, most for $1,000, the Cleveland Plain Dealer reported. "There is no question that members of Congress and their staffs listen carefully to Sallie Mae, probably too carefully," says Michael Dannenberg, director of education policy at the nonpartisan New America Foundation.

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Alan Collinge took out $38,000 in loans, which he later consolidated with Sallie Mae, for his undergraduate and graduate degrees in aerospace engineering. He got a job as an associate scientist in aeronautics at Caltech and paid off $7,000 of his loans. But after leaving that job he was unable to find another one, and eventually he stopped making payments. He says he asked Sallie for a grace period, but the company refused. With compound interest, he now owes more than $100,000 and is unable to find work in his field because of his bad credit record. Instead he works in tech support for a nonprofit group in Tacoma. Collinge says he has offered to repay the $38,000 he borrowed, but he says the collection agency will not accept a compromise and is attempting to garnishee his wages.

So Collinge has become an activist. He has started a website called studentloanjustice.org, where former students share their stories of how their loans have wrecked their lives, and he has put together a presentation called "The Bully in the Schoolyard: Why Sallie Mae Must Be Stopped," which he is trying to get heard in Washington.

Collinge's loan, like others, has tripled not only because of compounding interest but also because of the fees--as much as 18.5% of the outstanding value--that get tacked on as a student loan passes from a lender to a guaranty agency to a collection agency. You can see how a defaulted loan could actually be quite profitable for a lender that also runs the guarantor and owns the collection agency. Collinge points to Lord's 2003 letter to shareholders, in which the CEO attributes Sallie's record earnings per share in part to the fees it made by collecting on defaulted student loans. Debt collecting, which can be an ugly business, now accounts for 18% of Sallie's revenues. (The company says that a loan that is being repaid is far more profitable than one that has gone into default.)

That is hardly the only way Sallie plays rough with students who have signed up for its loans. Right now there is a storm of controversy surrounding its business with for-profit schools, which are accused in multiple lawsuits in several states of using hard-sell tactics to recruit students, promising them high-paying jobs that don't materialize and leaving them with mountains of debt that they can't pay off.

Consider a complaint that was filed with the Pennsylvania Department of Education in 2004 against a school called Katharine Gibbs, owned by a for-profit chain called Career Education. Documents examined by FORTUNE, obtained by a source through a Freedom of Information request, indicate that a student took out a $6,500 loan from Sallie Mae. The student, who isn't identified, alleges that he was never told that the interest rate would be 14% annually. In fact, a copy of the loan document reveals that after Sallie tacked on a "supplemental fee" of 9% of the loan balance, the annual cost of the credit while the student was in school was actually over 28%. Today the student owes $18,000. (Sallie says its average private loan rate nationally is about 8%.)

The most recent furor of bad publicity for Sallie involves another Pennsylvania school, Lehigh Valley College, which is also owned by Career Education. LVC charges around $30,000 for degrees in subjects like massage therapy; in recent years Sallie has provided many of the loans. (A small bank in Oklahoma called Stillwater makes the initial loans, which Sallie then purchases.) Last spring a local newspaper, the Morning Call, published a string of stories recounting the experiences of students who found themselves paying double-digit interest rates and discovering that they owed as much as $100,000--roughly 2½ times what they'd borrowed--because of compounding interest. At an informational meeting called by the Pennsylvania House Consumer Affairs Committee, Sallie admitted that it charges LVC students an average annual interest rate of 13% on their private loans, and that it sends the loans through Stillwater because the legal interest rate limit is 21% in Oklahoma, compared with 18% in Pennsylvania. House members were outraged. "Are you really doing a real service here by getting people into astronomical interest rate situations?" asked representative Reichley.

A lawsuit filed by former LVC students against the school alleges that LVC "led plaintiffs to believe that the loans ... were low-interest, government-guaranteed, or student loans, when in reality the loans were not government-backed loans and included interest rates in excess of 15%," and that LVC "intentionally hurried Plaintiffs through the financial aid process using aggressive sales tactics." Sallie, which isn't named in the suit, says it needs to charge high interest because students can be bad credit risks.

Career Education says its "intent is to address any issues that arise thoroughly, thoughtfully, and promptly." Sallie says that the controversy in Pennsylvania is the result of its attempt last year to acquire a not-for-profit state agency called the Pennsylvania Higher Education Assistance Authority, or PHEEA, which is a major lender in the state. PHEEA flatly refused Sallie's bid; spokesperson Keith New claims that selling to Sallie "would have been a very bad outcome for students." But Sallie says that the politically connected PHEEA is protecting its own lucrative business and that the uproar over LVC is simply a "political exercise" ginned up by PHEEA.

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There are doubtless some investors who don't care about any of this as long as it benefits the bottom line. But a big question looms in Sallie's private credit business: How many students who take out these high-interest loans will end up defaulting? After all, private credits are basically unsecured loans to people without jobs. Sallie argues that there won't be a problem. Each quarter it books a reserve for potential losses; at this time its losses on private credit loans in repayment are running at only 2.4%. Plus, Sallie says, almost half its private credit loans are guaranteed by a parent.

But because private credit is a new business and because students are taking on unprecedented levels of debt, there are no historical measurements by which to gauge potential defaults. As Sallie's financials note, "The provision for loan losses is inherently subjective as it requires material estimates that may be susceptible to significant changes." And the current low delinquency rate may be misleading, because as of the end of 2004 nearly half the students to whom Sallie has lent private money hadn't left school yet.

Some worry that Sallie may already be struggling to deliver on its promises to Wall Street. The company encourages investors to look at a measure it calls "core cash" earnings, which, among other adjustments, strips out the gain Sallie books when it sells loans to an off-balance-sheet trust and replaces it with Sallie's estimate of the spread those loans are earning. In other words, Sallie's "core cash" results are affected by the reserve it books on those off-balance-sheet loans. Over the past year the company has reduced its reserves, thereby boosting the earnings measure that it encourages investors to watch. Currently Sallie's allowance for losses on the private credit loans that are in repayment is 3.9%, down from 6.2% a year ago. Sallie attributes the reduction to an improvement in its portfolio's credit quality and says that the idea that reducing reserves helps earnings is wrong.

In coming years Sallie will be facing a headwind, regardless of how the HEA legislation plays out. That's because of the breakup between Sallie and one of its major business partners, J.P. Morgan Chase. In early 2005, J.P. Morgan Chase sued Sallie to escape from a joint venture under which J.P. Morgan Chase sold Sallie all the student loans that were originated under its brands. J.P. Morgan Chase alleged that Sallie was pushing its own brands at the expense of the joint venture, and the two dissolved their partnership in March. This was big business--these brands accounted for some 60% of FFELP originations over the past few years--and the breakup is part of the reason that analyst Ken Posner at Morgan Stanley rates Sallie's stock underweight. In fact, Posner predicts in a report that the dissolution of the deal will cost Sallie $26 billion in cumulative lost volume by 2010. Many investors are sanguine because Sallie's growth has remained strong this year, thanks partly to its private credits. But in the future there may be more and more pressure on those loans to deliver profits.

And that leads to the larger question: Sallie's reputational risk. Student loans aren't just another business like software or laundry detergent. If the ugly headlines escalate, causing colleges, students, and politicians to think twice about Sallie Mae loans, its business will suffer. In the end, Sallie may find that if it doesn't do well by students, it won't do well by investors either.

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