Risky loans were being awarded for months after the run on the bank
The Treasury has been criticised for allowing Northern Rock to lend £800m in risky mortgages for six months after it was propped up with taxpayers' cash.
The National Audit Office report on the Treasury's handling of the crisis found the bank was still giving mortgages of up to 125% in early 2008.
It said the Treasury was aware of "potential shortcomings" in how to deal with failing banks as far back as 2004.
But it concluded nationalising the bank had protected taxpayers' interests.
Later on Friday Prime Minister Gordon Brown defended the nationalisation of Northern Rock, saying the government took action when necessary.
"The Treasury successfully met its objective to protect Northern Rock's depositors and stopped the run on the bank," said Tim Burr, head of the NAO.
"The Treasury could however 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," he added.
The report also concluded that ministers were slow to respond and under-prepared for the crisis.
The Treasury said it would study the report and respond to MPs this month.
However, Business Secretary Lord Mandelson told the BBC that decisions were made to allow Northern Rock to continue operating.
"There is absolutely no question whatsoever that saving Northern Rock, stabilising it, turning round the business as we are doing now is the right decision," he said.
"Can you imagine the consequences for savers, for mortgage holders, whose finances are intricately tied up with the fortunes of that company if we had just let it go?"
The NAO found Northern Rock continued to offer its Together mortgage - lending borrowers up to 125% of the value of their properties - from the time of its emergency support from the Bank of England in September 2007 until it was on the brink of public ownership in February 2008.
Edward Leigh MP, Conservative chairman of the public accounts committee, which oversees the NAO, said: "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 of up to 125% of a property's value.
"Why didn't the Treasury demand an immediate stop to the reckless lending that got the bank into trouble in the first place?"
The bank awarded a total of £1.8bn in Together loans, which exposed the bank to swift losses if house prices fell, between September 2007 and February 2008.
This amounted to 30% of all its mortgage lending at the time although the bank said £1bn of this extra lending had been agreed before September 2007.
The NAO criticises the Treasury for not having checked out the bank's finances thoroughly before it decided to nationalise it.
"In the lead up to public ownership, the Treasury did not commission its own due diligence on the company's operations, for example, on the quality of the loan book," the NAO said.
The NAO said greater scrutiny would have uncovered a much higher level of mortgage arrears than the Rock had previously admitted.
ROCK MORTGAGE BREAK-DOWN
33% borrowed more than 100% of house value
10% borrowed 95%-100% of house value
7% borrowed 90-95% of house value
Source: Northern Rock annual report
The report also said the Treasury had been aware of "potential shortcomings" in dealing with a failing bank as early as 2004.
However, it was "not judged by the Treasury to be a priority in a benign economic environment", the report said.
Shadow chief secretary to the Treasury Phillip Hammond said the NAO report was a "hard-hitting indictment" of how the government handled Northern Rock's nationalisation.
"It now emerges there were major due diligence failures at the Treasury both before and after nationalisation - which have resulted in the bill for taxpayers being even bigger than was previously thought," he said.
And Liberal Democrats Treasury spokesman Vince Cable said: "With billions of pounds of public money at stake, the least taxpayers should expect is that basic due diligence of the company's loan book should have taken place before nationalisation.
"It seems ministers were keen to hide the scale of the bill that taxpayers were being asked to pick up."
A Treasury spokesman said the department would study the report and reply to the public accounts committee at the end of the month.
The BBC's Business Editor Robert Peston said that the report was embarrassing for Gordon Brown and Alistair Darling as "a spotlight has been shone again on their misjudgements".
"But we've known for many months that they were wrong on these very big issues," he said.
Northern Rock, which had grown to become one of the UK's biggest mortgage lenders, had to be bailed out by the Bank of England in September 2007 when its funding from other banks evaporated.
September 2007: BBC reveals that Northern Rock has been granted emergency financial support from the Bank of England
February 2008: Northern Rock is nationalised
March 2009: The Rock confirms that it made a loss of £1.4bn in 2008
It was subsequently nationalised "temporarily" by the government, as the international banking crisis deepened, and no viable private sector bidder came forward.
One result of its high-risk lending was a rapid increase in the bank's exposure to actual and potential losses.
Falling house prices last year meant that by the end of December 2008, 33% of all Rock mortgages had fallen into negative equity - up from just 0.5% a year earlier.
Along with growing arrears among borrowers, this meant the bank needed a much higher financial cushion, so the Treasury had to give it a further £3bn in July 2008.
Many commentators expect house prices to fall by at least 10% this year, and probably more.
Northern Rock recently announced a loss of £1.4bn for 2008, mainly stemming from its arrears and losses on selling repossessed homes.