Council chiefs have called for extra powers to allow them to offer competitive mortgages in an attempt to rescue the housing market.

In a letter published in today's Times, they argue that the public sector should be able to help first-time buyers and those unable to secure a home loan. Critics believe that the move could lead to higher council tax if borrowers defaulted.

The councillors want to borrow an extra £2 billion from the public works loans board, a Treasury agency that allocates funding for capital public sector projects. They are pressing for the idea to be discussed at a Cabinet meeting on September 7, when the Prime Minister is expected to draw up the Government's solution to the housing crisis.

Caroline Flint, the Housing Minister, is said to be sympathetic to it but Treasury ministers are less so.

Figures published yesterday by the Council of Mortgage Lenders show that the lending rate fell by a third in the year to July. The council also said that it expected the mortgage market to shrink by 20 per cent this year.

Chris Leslie, director of the New Local Government Network and a signatory to the letter, said that councils wanted to save people from being kicked out of their homes. He said that councils could raise millions of pounds over the next decade by offering cheaper mortgages than the private sector.

With public borrowing increasing further, Whitehall officials believe that the risk to council taxpayers and the Government would be too high.

One source told The Times that those who applied for town hall mortgages were likely to be those most at risk of defaulting. He said that it was unlikely that the Government would want to take on such a risk by approving further borrowing.

Liverpool City Council is set to introduce a mortgage scheme shared with a private lender and has stated that all those offered mortgages will be creditworthy. “We are talking about people who were offered a mortgage a few months ago, when the lenders were offering 95 per cent mortages, but are unable to do so now that deposits of 15 per cent are required,” it said.

Solutions to the mortgage crisis are proving problematic for the Government. Last week Mervyn King, the Governor of the Bank of England, criticised two plans that the Treasury was considering.

Councils are allowed to offer mortgages but regulations introduced in the Eighties ties them to an uncompetitive interest rate and prevents them from undercutting private sector rivals. “In 1980, 600,000 mortgages with homeowners were held by local authorities,” the councillors say in the letter. “Since then, the banking industry has almost universally taken on this role.

“The Government should recognise that local authorities are well placed to judiciously take a share of mortgage business.”

The Council of Mortgage Lenders welcomed the plan but said that councils would have to be subject to Financial Services Authority rules. The British Banking Association suggested that local authorities could end up being stung by the tough mortgage market conditions.

Andy McQueen, managing director of Nationwide's specialist lending division, said: “It would be good news for customers if it got off the ground but it would not be done in a couple of months.”

The councils would need proper resources and experienced staff to make the scheme work, he said.