On the same December day Merrill Lynch & Co. Inc. paid $1.3 billion for a subprime lender, the world's largest brokerage got a rude introduction to risky mortgages.

Merrill Lynch's newly minted First Franklin Financial Corp suffered a loss of nearly $300,000 on a soured home loan to a lab assistant from a gritty, blue-collar town north of Boston.

Problems with subprime mortgages have buckled Wall Street-run hedge funds, roiled global credit markets and pushed several of First Franklin's rivals into bankruptcy, leaving thousands of U.S. workers jobless.

And First Franklin's lawsuits against mortgage brokers show the San Jose, Califorina-based lender has experienced the same problems as the rest of the industry. Court papers show First Franklin has been burned by lax underwriting, fraudulent home appraisals and borrowers exaggerating their incomes.

A few bad loans at First Franklin are not a disaster for Merrill Lynch, a financial powerhouse with $1 trillion in assets, But the subprime mortgage industry's crisis has sidelined Merrill's strategy for buying the lender in the first place. Home loans generated by First Franklin are the raw material Merrill Lynch packages into mortgage-backed bonds sold to investors. That market has nearly evaporated.

Merrill Lynch executives are not sure if First Franklin will add to 2007 profits, as they had forecast last year.

So far it appears to be a drag on earnings.

BAD TIMING?

It wasn't the best move, said John Meara, president of Argent Capital, which owned 309,000 Merrill shares at the end of June. It's not going to make or break the company, and I'm sure the company didn't factor in what's happened to the subprime industry. It's hard to predict Armageddon.

Merrill declined to provide any detailed information about First Franklin's performance. But recently filed reports with U.S. banking regulators show that Merrill Lynch Bank & Trust Co., where a lot of the First Franklin franchise is housed, lost $111 million through the first half of 2007. Securitization and trading revenue tied to First Franklin's loan making are not included in that unit's results.

The subprime crisis gathered momentum shortly after Merrill Lynch announced in September it would buy First Franklin from National City Corp. Defaults on subprime loans escalated to record levels, prompting analysts to question the timing of Merrill's plunge into subprime lending.

While First Franklin relies heavily on an army of independent brokers to find borrowers and submit loan applications, other U.S. lenders have abandoned that channel, citing problems with underwriting and outright fraud.

Overall, our experience with mortgage brokers has been excellent, Merrill spokesman Bill Halldin said.

But if brokers turn in fraudulent loan documents, the company said it takes aggressive action, including ending the relationship or going after them in court.

HIGHER PERFORMANCE?

In March, First Franklin Chief Executive Andrew Pollock sought to put distance between his company and subprime lenders going out of business. His testimony before the Senate banking committee highlighted how First Franklin originated loans with higher credit scores, lower delinquency rates, and generally higher performing mortgages than many other subprime lenders.

A critical component of our success has been the disciplined underwriting we embrace, he said.

Pollock did not talk about lab assistant Marielite Hardy who received $670,000 in loans from First Franklin in March 2006 to buy a multi-family home in Revere, Massachusetts.

Her loan application, submitted by mortgage broker National Lending Corp., listed her monthly income as $12,000. This month, First Franklin accused the Houston-based broker of inflating Hardy's income by about $9,000, according to a lawsuit filed in U.S. District Court in Boston.

The lender has filed several other lawsuits against brokers in the last year. Merrill said it ended its relationship with National Lending, which denied any wrongdoing. Hardy is not a defendant in the case.

Hao Nguyen, National Lending's operations manager, said the dispute is over a stated income loan, or one that does not require documentation of income.

After funding the Hardy loans, First Franklin sold the first loan on the property to a U.S. unit of London-based bank HSBC in the secondary mortgage market.

First Franklin said Hardy did not make a single payment. HSBC demanded First Franklin buy back the loan, according to court records. First Franklin did and then sold it in a distressed sale, taking a $295,908 loss.

Several months after First Franklin funded Hardy's loan, the lender received her wage verification from her employers. The documents showed that her wage income fell far short of justifying the money she received.

These lenders want to loan money to people without guidelines, Nguyen said. And then they get burned.