Sallie Mae's private side

NEW YORK (Fortune) -- The lure for private-equity firm J.C. Flowers' $25 billion buyout of student-loan giant Sallie Mae may be its fast-growing and lucrative business providing private education loans -- loans that exist outside the government-backed student-loan program. But these unregulated loans, which can carry double-digit interest rates, may ultimately prove to be a messy business.

Even before the buyout, student loans had come under high-profile scrutiny. New York State attorney general Andrew Cuomo launched an investigation into the cozy arrangements between lenders and schools, getting two major banks to agree to a code of ethics. Senator Edward Kennedy (D-Massachusetts) wants to slash the government-guaranteed profits that lenders make.

Private loans, though, lie beyond the government's reach and so far have gotten little attention. At present they are a profitable and fast-growing market. Unlike government-backed loans, whose interest rates are set by law--6.8% for the most popular kind, which are called Stafford loans--private loans have no such caps. Lenders, therefore, can charge whatever interest rate students will pay, barring state usury laws.

Sallie says its average interest rate on private loans is about 10.5%, but rates can get much higher--and that doesn't include fees, which can add as much as 6% to the balance of the loan. These loans are more profitable than government-backed loans. While they constitute 16% of Sallie's $142 billion lending portfolio, private loans make up 23% of the company's profits.

As college tuition has risen sharply and government aid has failed to keep up, private loans have exploded. Since 2001 the market for private loans has grown at an annual rate of 27%, says the College Board, to $17.3 billion in 2006--roughly 20% of total student borrowing.

But in student-loan circles, private loans are controversial. Their high rates of interest can add on tens of thousands of dollars of debt--seldom expungable in bankruptcy. And while they may make sense as a last resort to fill the gap between available federal aid and the cost of tuition, private loans aren't always being used that way.

"It is troubling that a substantial portion of private borrowers had not obtained or maximized federal loans," the Institute for Higher Education Policy says in a recent report. (Just why borrowers would choose private loans over cheaper government loans is unclear; experts suggest a combination of student naiveté and lender marketing.)

In addition, the growth in private credit appears to be linked to the growth in publicly traded, for-profit schools--think Corinthian Colleges and the University of Phoenix. Already facing a mix of lawsuits and state and federal investigations for aggressive marketing tactics, among other things, the for-profit education sector has been particularly lucrative for lenders.

According to the College Board, 40% of students graduating from for-profit schools in 2004 had more than $30,000 in debt, compared with 14% of graduates of public colleges and universities. And undergraduate students attending for-profit schools are more likely to take out private loans than undergraduates at any other type of school, says the Institute for Higher Education Policy.

Sallie Mae (Charts, Fortune 500) doesn't disclose the percentage of its private loans to students at for-profit schools. But it has extended loans to students of Career Education, a chain of for-profit schools currently facing six lawsuits by former students--some of whom have complained they weren't told they would graduate with well over $50,000 in high-interest Sallie Mae debt.

Sallie Mae denies any wrongdoing: "We mislead no one and make full disclosure of rates and fees," says spokesman Tom Joyce. A spokesperson for Career Education says it is "committed to giving students all loan information available and to working with lenders who are committed to full disclosure on their end."

Private loans may be more than a just a PR problem. Since the business is still relatively new and the loans aren't yet "seasoned," it isn't clear what their default rates will be over the longer term. Sallie has said publicly in the past that less than 2% of its private-loan portfolio defaults. But when the company released its second-quarter earnings in late April, the figure had spiked to 3.4%. That number doesn't include loans that are delinquent or in forbearance, or on which payment has been deferred.

Nor is private credit immune to becoming a political hot potato. Another part of Kennedy's student-loan-reform agenda would, among other things, require lenders and schools to be more explicit about the higher cost of private credit. Some were surprised when, on a recent analyst call, Sallie Mae CEO Tim Fitzpatrick accused Kennedy of attempting to "smear the integrity of Sallie Mae" and the industry. But down the road, Sallie's new owners, who did not return calls for this story, may find themselves tarred with a similar brush.