The Government's financial track record suffered a fresh dent today as it emerged it was preparing to write off up to £3 billion of taxpayer-funded loans to Northern Rock to strengthen the stricken bank's balance sheet.

Rock revealed today that it had crashed to a worse-than-expected £585 million loss in the first six months of this year partly because of a blow-out in borrowers failing to meet their interest bills.

The nationalised bank said today that while it was making good progress in repaying loans to the Bank of England and attracting new depositors, it had been hit by the deteriorating external environment.

The Treasury is preparing to convert up to £3 billion of government loans to the Rock and £400 million of Rock preference shares into ordinary Rock shares.

A Rock spokesman said the debt-for-equity swap would have no cash benefit because the bank would pay a higher interest rate for the remaining loans.

"These actions to be taken to improve the regulatory capital position of the company will not change the Government's net cash exposure to Northern Rock," the bank said.

However, sources close to the deal conceded that the balance sheet rejigging could result in taxpayers ultimately losing more if the state-sponsored rescue of Rock was unsuccessful.

Rock's loan losses ballooned from £56.8 million in the first half of 2007 to £191.6 million. Rock also incurred one-off expenses of £165.6 million, including a provision of £37 million for redundancies and £35.6 million in fees to City advisers. Staff numbers are to be cut by about 2,000.

Ron Sandler, chairman of the bank, said the losses were likely to continue as the credit environment remained difficult. But he added: "I am confident that the foundations have been well laid for recovery and return in due course to private ownership."

Chancellor Alistair Darling said that after carefully considering the value-for-money case, he was satisfied the refinancing was the best way of meeting the Government's objectives. Many banks in the UK had had to boost their equity capital positions in recent months and Rock was in the same position, he said in a letter to John McFall, chairman of the Treasury Select Committee.

The move, which requires state aid approval from Brussels, would not count as an increase in government spending but would add to public sector net debt. "The value of the additional equity will be reflected in the sale price for Northern Rock on return to the private sector, which will reduce public sector net debt at the point of sale," Mr Darling argued.

He stressed that the government guarantee to Rock depositors remained in place. Rock revealed that it had attracted £3.7 billion of new net savings in the half year.

Mr Darling told BBC Radio 4's Today programme that Britain's economic woes will continue "for some time" but refused to explain why taxpayers are being put at risk of losing £3 billion after Northern Rock converted a chunk of its debt into equity.

He said: "It needs more shareholder capital, it does not have shareholders so it has to come from us."

He added that the "difficult situation" the UK and "other countries" face "is going to continue for some time", and said: "It will be more prolonged than we thought a year ago".

The Chancellor insisted the Government was "doing everything we can" to help Britons through the current economic slowdown but declined to comment on whether Labour would cut or abolish stamp duty on home purchases, stating only he was looking at "a number of options".

Mr Darling said that the Government would not change the criteria the Bank of England uses to decide on interest rates to include future forecasts of inflation as well as current figures.

The Bank of England's Monetary Policy Committee will meet this week to decide on interest rates, which are widely expected to remain at 5 per cent.

The number of Rock mortgage borrowers more than three months in arrears has doubled in the space of six months to 1.18 per cent of the overall home loans book. It has also been repossessing defaulting borrowers' homes at an accelerating rate, with properties in possession rising from 2,215 at the start of the year to 3,710.

Rock warned that it was particularly vulnerable to the housing market deterioration because of its past practice of offering big loans relative to the value of homes.

Rock has reduced its debt to the Bank of England by £9.4 billion to £17.5 billion. The stricken bank was nationalised in February after attempts to orchestrate a private sector rescue foundered.

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