According to London reports, the rescue of the failed mortgage bank, Northern Rock — the most high profile example of Government intervention to try and limit the damage from the credit crunch — could match or surpass the amount the British Government spends on defence.

It’s costing the Government tens of billions of dollars a week as the Bank of England is forced to pump more and more money into Northern Rock to replace funds draining out the backdoor.

Much of its wholesale funding has gone and now it seems retail deposits above and beyond those withdrawn during the run in August, are disappearing, forcing more aid from the Bank of England.

This week’s Economist put the problem in stark terms:

The government is thought to have put in up to £23 billion ($48 billion), and the sum is growing by £2 billion-3 billion a week as depositors continue to flee. At least £10 billion of the bank’s £24 billion in retail savings has already been withdrawn, some say, and Northern Rock is having little luck persuading banks to lend it new money as its existing loans come due. State support for Northern Rock already exceeds Britain’s transport budget and could soon surpass the £32 billion allocated to defence—a particular embarrassment for a government accused of under-equipping its soldiers in combat zones.

And there’s no prospect of any improvement with the Financial Times reporting overnight that plans to rescue and revamp the lender contain bad news for existing shareholders, who will lose everything, and the Bank of England, which will be on the hook for billions of dollars in aid for years to come.

According to documents seen by the Financial Times and appearing on its Alphaville blogsite, there are three plans for the revamp of Northern Rock.

The paper says the information memorandum, prepared by Merrill Lynch, Citigroup and The Blackstone Group, has been sent to all potential acquirers of the stricken mortgage bank, which has been codenamed Blackbird:

Three structures have been suggested, each of which has been illustrated in “normal” and “constrained” market scenarios, ranging from a complete takeover of Rock to a so-called “Platforms Company” – a shrunken version of Rock, shorn of its pesky wholesale fundings and securitisations, its Bank of England loan, and also its existing shareholders.

Sources indicated to FT Alphaville that under the various structures, while Rock is forecast to return to remarkably healthy profitability, existing investors will be wiped out and the Bank of England may be left holding billions of Rock debt through until 2010.

A briefing memorandum prepared for prospective buyers of Northern Rock by the bank’s advisers Merrill Lynch, Citigroup and Blackstone Group details a number of future scenarios for the bank.

The memo also makes clear that Northern Rock will owe the Bank of England billions of pounds well into the future, even with a drastic reduction in the bank’s mortgage book.

Financial advisers, who refer to Northern Rock by the code name “Blackbird” in the memorandum, predict the bank will still owe as much as £5.88bn to the Bank of England in 2010.

The push to sell Northern Rock is expected to surface this week with prospective buyers submitting formal proposals to take control of the group. The bidders including JC Flowers & Co a private equity group from the US, Sir Richard Branson’s Virgin group and another US buy-out group, Cerberus.

The reports in the FT and in other London papers in recent days suggest the British Government will have to leave billions of dollars in the bank by way of direct aid, soft loans or a capital contribution, for the rescue to work.

Otherwise it will have to remain on the lifeline from the central bank until it can be put down.