Merrill Lynch & Co. (MER) said Tuesday that it agreed to buy National City Corp.’s (NCC) subprime mortgage unit for $1.3 billion.

Merrill’s acquisition of First Franklin and its affiliated businesses — the nation’s no. 9 subprime mortgage lender, last year originating more than $29 billion in loans — is the latest indication of Wall Street’s efforts to beef up in the mortgage space. At a time when a cooling housing market threatens to damp the supply of mortgages, investment banks are looking to bring lending capabilities in-house to help them meet the growing demand for mortgagebacked securities.

The deal comes as many observers think the mortgage market is peaking. That has prompted commercial banks such as KeyCorp (KEY) to mull sales of their mortgage businesses.In this environment, some investment bankers say that virtually all mortgage lenders are up for sale.

In addition to the loan-writing infrastructure, National City is selling Merrill about $5.6 billion of mortgage loans that First Franklin originated but that National City later bought. That transaction, whose terms weren’t disclosed, still leaves about $10 billion of First Franklin-originated loans on National City’s balance sheet. National City said it “will continue to consider strategic options for the remaining portfolio, including sale, securitization or ongoing retention and run-off over time.”

Gerard Cassidy, an analyst with RBC Capital Markets, said National City investors may be disappointed that the company didn’t sell the entire $15.6 billion loan portfolio. He said Merrill apparently shied away from the full subprime portfolio due to concerns about credit risks. A Merrill spokesman declined to comment.

“Merrill obviously didn’t want to take that risk of the additional $10 billion,”Mr. Cassidy said.”The deal is less satisfying to investors than if they were able to unload everything. There’s still a chunk of exposure that they’re left to deal with in coming months.”

Still, National City shares climbed 26 cents, or 0.8%, to $34.83. Merrill shares rose 18 cents, or 0.2%, to $73.95.

National City said the First Franklin sale will generate a roughly $1 billion pretax gain, or about $1 a share after taxes. National City Chief Executive David A. Daberko said the proceeds will allow the bank to focus on its core consumer businesses. Already, the Cleveland-based bank has announced two deals to buy small Florida lenders.

For Merrill, the acquisition “accelerates our vertical integration in mortgages,” which could become more important if the supply of mortgages dries up, said Dow Kim, president of Merrill’s global markets and investment-banking group, in a statement Tuesday.

Merrill is just the latest investment bank to snap up mortgage companies, following the leads of Lehman Brothers Holdings Inc. (LEH) and Bear Stearns Cos. (BSC), which boast Wall Street’s biggest mortgage-origination businesses. Last month, Morgan Stanley (MS) agreed to buy Saxon Capital Inc. for $706 million, while Deutsche Bank (DB) recently has purchased a number of mortgage lenders.

Merrill agreed to buy First Franklin after exploring a bid earlier this year for North Fork Bancorp (NFB), which had a strong mortgage business. Merrill already has bought three smaller subprime mortgage companies, including originators Freedom Funding Ltd. and Mortgages PLC in the U.K. this year, and mortgage servicing firm Wilshire Credit Corp. in 2004.

“This acquisition, and the origination platforms in particular, fills an important gap for us domestically providing a significant presence in both the wholesale and online retail channels,” said Michael Blum, head of Merrill’s global structured finance and investments group.

Merrill said it will continue to operate First Franklin and its affiliated businesses — National City Home Loan Services and NationPoint — under their current names as distinct units. Merrill said the deal, which is expected to close in the fourth quarter, will add to its earnings by the end of next year.

While Merrill may have cut down on risk by not buying National City’s full subprime mortgage portfolio, the transaction still carries risks.

Despite the strategic value of investment banks controlling their own supply of mortgages to securitize, entering new retail businesses creates managerial challenges.

Merrill will integrate the approximately 2,800 employees of the National City mortgage units into the global structured finance and investments group of its institutional trading and investment banking division. Analysts for the past year have speculated that Merrill may purchase an entire bank to beef up its retail lending portfolio, but Merrill Chief Executive Stanley O’Neal and other executives have said they will remain disciplined in pursuit of consumer businesses.