The Government faced fresh accusations of financial incompetence from the Opposition yesterday as it prepared to write off up to £3 billion of taxpayer-funded loans to Northern Rock to strengthen the stricken bank’s balance sheet.

Rock reported yesterday it had crashed to a worse than expected £585 million loss in the first six months of this year partly because of an increase in the number of borrowers failing to meet their interest bills.

But it was the news that the Treasury was willing to swap public loans to Rock for potentially inferior equity that sparked a political row, with the Conservatives accusing ministers of incompetence and misleading taxpayers.

Philip Hammond, Shadow Chief Secretary to the Treasury, said: “Gordon Brown and Alistair Darling promised taxpayers the loan to Northern Rock would be repaid in full. But now, just six months after nationalisation, we learn part of that loan is being written off to recapitalise the bank after these disastrous losses. Once again, we are seeing how this Government just can’t be straight with people.”

The debt-for-equity swap would strengthen Rock’s balance sheet and shore up its capital ratios, which have been hit by the first-half losses. Advisers to the deal emphasised that it would involve no fresh public money being put into the bank. However, they conceded that the balance sheet rejig could result in taxpayers ultimately losing more if the state-sponsored rescue of Rock was unsuccessful.

Jonathan Loynes, of Capital Economics, said: “This raises the possibility that UK taxpayers will be more heavily exposed to Northern Rock and for longer than had been envisaged.” However, in a letter to the Treasury Select Committee, Mr Darling defended the equity injection, saying that he was satisfied the refinancing was the best way to meet the Government’s objectives.

The nationalised bank said 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 economy. As well as converting loans to equity, the Treasury is also prepared to accept the downgrading of £400 million of preference shares to ordinary shares. Creditors and preference shareholders stand higher in the queue than ordinary shareholders in the event of a winding-up of any business.

A Rock spokesman said the debt-for-equity swap would have no cash impact because the bank would pay a higher interest rate for the remaining government loans. 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 2,000.

Ron Sandler, chairman, 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.”

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 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 at a private sector rescue failed.

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