Northern Rock bidders told to improve offers

The government has asked two suitors competing to rescue Northern Rock to improve their offers or it will nationalise the country's fifth-largest mortgage lender - an option the government would rather avoid.

A consortium led by billionaire Richard Branson's Virgin group has been told it is a front-runner in the race, ahead of a rival "in-house" offer led by the bank's management team, Treasury officials said.

Both bidders, however, were asked to offer better terms because they did not offer a good enough deal for the taxpayer.

"We are in intensive discussions with Virgin but all options remain on the table," Chancellor Alistair Darling told BBC radio. "Of course the option of a short period of nationalisation has to remain on the table".

The Northern Rock debacle has become a major headache for Prime Minister Gordon Brown, tarnishing his popularity and denting a reputation for financial stability. The bank already owes taxpayers £25 billion and has been put on the government's books as some £90 billion of debt.

However, a significant improvement of the bidders' terms could prove difficult, given difficult financial markets and an uncertain outlook for the mortgage sector and bad loans.

The government has sought to avoid the political embarrassment of putting Northern Rock into public ownership, but Treasury officials warned on Wednesday that unless terms were improved, nationalisation was currently seen as a better option.

Several sources familiar with the negotiations, however, said the government had little appetite for an actual nationalisation, and was instead hoping to pressure the two suitors to sweeten their proposals. One high profile bidder, investment group Olivant, has already quit the race, blaming the difficulty in satisfying all stakeholders in Northern Rock.

"They're using nationalisation as a stick," one source said.

"Virgin are ahead at the moment but they would need to improve their offer before the government is ready to do a deal," one source close to the talks said.

A spokesman for Virgin said the group would continue to talk to the government about its proposal, but declined to comment further.

Northern Rock said the in-house team was also in ongoing talks with the government about its proposal.

News that Virgin may be ahead, though, will be a blow to the bank's larger shareholders as that proposal would significantly dilute existing investors' stakes.

But, in a show of confidence in the in-house proposal, the bank's largest shareholder, hedge fund SRM, lifted its stake to 11.5 per cent from 10.8 per cent, raising the potential for a shareholder battle if Virgin wins out.

Both Virgin and the bank's management have already indicated they would give the government a share in future profits.

Sources close to the bidders, though, said neither side had been given specific indications of what to improve.

Virgin, whose bid is led by former Lloyds TSB boss Brian Pitman and Virgin Money head Jayne-Anne Gadhia, plans to inject more capital and to rebrand the bank as Virgin Money.

The management-led alternative, led by former investment banker Paul Thompson, would keep the brand but would pull back from aggressive lending, halve the asset base and boost retail deposits to bring the bank back to its healthy levels of 2003.