By JANE WARDELL

LONDON (AP) ¿ The British government allowed Northern Rock to continue making risky loans for another six months after it became the first bank to receive a state bailout, a report by a public spending watchdog revealed Friday.

In the most damning review so far of the government's ability to contain the financial crisis, the National Audit Office also said the Treasury knew about shortcomings in banking oversight as far back as 2004 ¿ but did not make the issue a priority.

The office concluded overall that the government was right to step in and take control of Northern Rock given the potential loss to taxpayers from a private sale, but that finding was overshadowed by critical detail in its 58-page report revealing that lawmakers were underprepared and slow to respond to the crisis.

"The government dithered over this for months and a great deal of damage was done," Vince Cable, a lawmaker in the opposition Liberal Democrat party, told the BBC.

Cable added that the government appeared to have learned from some of its early mistakes, but said that concerns remained about the government's ability to direct other banks it has since taken majority stakes in, including the Royal Bank of Scotland, one of the world's biggest financial groups.

The audit office said the Treasury was aware in 2004 of "potential shortcomings" in its plans to deal with failing banks. However, it was "not judged by the Treasury to be a priority in a benign economic environment."

Just three years later, the credit crunch led to the collapse of Northern Rock and began a banking crisis that drove Britain into recession.

The report said that Northern Rock continued to give mortgages of up to 125 percent of the value of a home from the time it received emergency funds from the Bank of England in September 2007 until shortly before its nationalization in February 2008.

At that time, the government was struggling to calm panic among customers that resulted in the country's first bank run in more a century.

"While depositors were queuing up outside branches to withdraw their money and the Treasury was pouring public money in to stabilise the Rock, the bank was still ploughing on with awarding mortgages up to 125 percent of a property's value," said Edward Leigh, an opposition Conservative lawmaker and chairman of the Public Accounts Select Committee. "Why didn't the Treasury demand an immediate stop to the reckless lending that got the bank into trouble in the first place?"

The audit office said the Treasury also failed to properly assess the risk or challenge Northern Rock's overly optimistic business plans when it was considering nationalization, noting that a more detailed assessment would have uncovered a much higher level of mortgage arrears than the lender had previously admitted.

Northern Rock's business plan was based on a 5 percent fall in house prices in 2008, yet house prices dropped 15.9 percent over that year. The lender's 585 million pound loss in the first half of last year was also far worse than its 300 million pound base estimate.

"The Treasury could ... have conducted a more systematic assessment of the risks it was taking on and more thoroughly tested the bank's initial business plan in public ownership," said Tim Burr, head of the audit office.

The lack of expertise at the Treasury was highlighted by a massive 79 million pounds paid in advisory fees on the deal, including 27 million pounds incurred directly by the Treasury and 39 million pounds spent by Northern Rock.

The audit office said the Treasury "learned lessons from its experience" and was "better prepared" by the time the government nationalized mortgage lender Bradford & Bingley PLC in September 2008. The following month it took stakes in Royal Bank of Scotland Group PLC and Lloyds Banking Group PLC.

Prime Minister Gordon Brown's office said that risky mortgages were stopped as soon as the government obtained the legal powers to do so and that the Treasury began making preparations for the possible collapse of a major financial institution after concerns were raised in 2004.

"But as the Chancellor and the Prime Minister have also said, there will be lessons that we have to learn from the global financial downturn," a spokesman for Brown's office said on customary condition of anonymity.

Copyright 2009 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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