RPT-UPDATE 3-Northern Rock Bidders Told to Improve Offers

(Writes through with details, N.Rock comment, updates shares)

By Sumeet Desai

LONDON (Reuters) - Britain has asked two suitors competing to rescue Northern Rock NRK.L to improve their offers or it will nationalise Britain'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 on Wednesday.

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," finance minister 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 pounds ($49 billion) and has been put on the government's books as some 90 billion pounds of debt.

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

Britain 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.

A BETTER DEAL?

"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 percent from 10.8 percent, raising the potential for a shareholder battle if Virgin wins out.

The bank's volatile stock was down 6.7 percent at 98p at 1442 GMT, valuing the lender at just over 410 million pounds.

The Daily Telegraph said the improved terms the Treasury hoped to extract included a larger share in any future upside, for example greater share warrants and an improved fee for the government's deposit guarantee.

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 (LLOY.L) 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.

Virgin and the bank's management team submitted rescue plans for Northern Rock, Britain's biggest casualty of the global credit squeeze, last week. The government is expected to make a decision by the end of this month.

(Additional reporting by Clara Ferreira-Marques and Steve Slater; Editing by David Cowell/Elizabeth Fullerton)