Northern Rock must continue transferring mortgages to its offshore funding vehicle Granite or it will be forced over time to pay back the £49 billion owed to its investors.

Alistair Darling, the Chancellor, has insisted that it is up to Northern Rock’s new management team to decide whether it wants to continue its relationship with Granite. He has also said that any decision to wind down Granite would “ultimately have no impact on the taxpayers’ exposure”.

However, a senior source close to Granite gave warning yesterday that if Northern Rock decided to terminate its relationship with Granite then the stricken bank would be in “very difficult waters indeed”.

The source said: “That would be in effect a consensual decision to avoid a contractual liability. Granite exists and the obligations on Northern Rock as an originator [of mortgages] continues to exist. It is a financial reality.”

The warning came as Northern Rock last night scrapped mortgages worth up to 125 per cent of a property’s value, amid fears that the deals were exposing the lender to further bad debts and may have already left thousands of first-time homeowners facing negative equity.

Northern Rock set up Granite in 1999 as an offshore company, based in Jersey and moved a portion of its mortgages to the fund. Granite securitised – or sold bonds – against the mortgages. It then used the repayments on those mortgages to pay a coupon to the bondholders while the rest was siphoned off by Northern Rock to write new mortgages at cheap rates. When mortgages in Granite matured, or some defaulted, Northern Rock was contractually obliged to transfer over new ones. Sources have said that it is this tightknit relationship between Granite and the Rock that has forced the Government to insist that the Rock stay open for “business as usual” rather than being wound down. Mr Darling has insisted that Granite is an independent legal entity owned by its shareholders and that Granite alone is liable to its bondholders.

Yesterday, however, George Osborne, the Shadow Chancellor, highlighted an excerpt from Northern Rock’s annual report that said “the Granite group of companies are regarded as legal subsidiaries under UK companies legislation”.

Mr Osborne said: “It is increasingly clear that the Government do not know what they are getting into. Alistair Darling is only adding to the confusion over the status of Granite. How can he expect the taxpayer to take on so much risk when he cannot explain exactly what they are buying?” For accounting purposes Granite is listed as a legal subsidiary of Northern Rock. However, if Granite defaults or runs into trouble, bondholders only have claim over assets inside Granite, not inside Northern Rock.

The taxpayer may not be totally off the hook as sources said that if Northern Rock cannot feed Granite new mortgages then it could trigger a default and bondholders may sue the bank and the Government. Or if Mr Sandler decides to terminate the relationship with Granite, then the fund must be wound down. That can only happen if Northern Rock buys back the mortgages and gives Granite the cash to pay off the bondholders.

If Northern Rock is unable to sell on the mortgages, it will be landed with the bill. All £49 billion would have to be paid off and taxpayers would face an even higher bill. A Treasury spokesman said that the Government would not be liable to repay bondholders.

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive