How the wealthiest council in Britain ended up in debt after squandering a £263m windfall

Not since the 1850s, when its prolific fishing grounds were discovered south of Dogger Bank, had Hull experienced the kind of euphoria it was basking in three years ago. The city had landed a £263m windfall, which made it the richest local authority in England overnight.

The money came from the partial sale of the council's shareholding in Kingston Communications, the local phone company famous for its white telephone boxes, and delivered an advance taste of life in the big-spending world of second-term New Labour, where vast sums are thrown at long-suffering public services.

There were tens of millions of pounds to improve council buildings and schools, £32m for a new sports stadium and more than £90m to install double-glazing and central heating in thousands of council houses.

And there were some classic New Labour news management tactics to boot. To the local party's profound embarrassment, a leaked document revealed how politicians spending the windfall were considering plans to "drip-feed good news".

Yesterday, Hull's bubble was burst. Three months after the local Labour group was dumped from power after about 60 years of control, the city was on the receiving end of a withering Audit Commission report.

"Kingston Communications was a windfall for the council which, in its rush to spend, did not look closely at what its winners would be," said the commission's director of inspection Paul Kirby. "It needs to think much harder before it acts to get the most benefits for the most people of Hull."

It was enough to have John Prescott, the long-serving Hull East MP, shifting uncomfortably in his seat. He was in charge of local government between 1997 and 2001, while the windfall was being spent on his doorstep. It was also a shattering blow to Mr Prescott's home city, which is so intent on gaining "national top 10 status" that it has employed brand specialists Wolff Olins to formulate a new image in the past few years.

In many ways, Hull has been quietly succeeding, after years of mouldering away on the Humber estuary. Three months after it opened, the Deep, a £45m aquarium boasting the deepest fish tanks in Europe, has attracted 250,000 visitors, as many as it hoped for in its whole first year. The 25,000-seat stadium will soon house the local football and rugby league teams on the city centre's western edge – to the delight of thousands in this rabid rugby territory. A £150m regeneration scheme is also planned around the main railway station.

The city also has a new corporate image, including a cog-type symbol with five notches designed to represent its five pioneering qualities – leadership, creation, discovery, innovation and an ability to challenge.

But none of these was discovered by the Audit Commission. Its report demonstrated how, with minimal public or committee room consultation, the local Labour Party decided that £96m would be spent putting central heating and double glazing into 25,000 of the city's 38,000 council houses.

The logic was breathtaking, considering that about 3,500 of the city's 115,000 stock remain empty and that the people pouring out of the city's run-down Orchard Park and Bransholme council estates insist that the lack of local amenities and schools and the presence of crime are their problem, not the quality of their windows. Worse still, the municipality is still £20m in debt to the banks which loaned it capital to build the houses in the first place, in the 1960s and 1970s.

The ruling Liberal Democrat group, whose schadenfreude was unmistakeable yesterday, also claims that the kitchens and bathroom of the many council houses it has inherited are still not up to the Government's decent homes standards, despite the £95m spend.

"There could have been match funding for the council house spending at least," said Chris Jarvis, an independent councillor now in charge of housing. "The Commission has said the £95m spend wasn't necessary. Our council officers privately advised the same."

The Lib-Dems have always complained bitterly that the council house money was used to elicit votes. Four out of seven council estates which received house improvements first were in Liberal Democrat wards, where they were rushed through before local elections.

There were also claims from the Lib-Dems that the city's education provision was ignored at a time when Hull's schools were bottom of the national league table table for GCSE A to C grades; and that the spending plans were pushed through Hull's new cabinet structure without discussion.

Labour politicians immediately hit back, claiming with that their spending commitments reflected public desire. The issue of how to spend "KC" – as the Kingston windfallwas known – dominated local discussion in 1999 and when The Independent canvassed views in 1999. Council house improvements certainly emerged as the most popular form of social democracy. The strategy seemed to have worked when Labour returned to power in May 1999 with a bigger swing than any other municipality in the UK.

But beneath the surface, a history of poor leadership, in-fighting and bullying by interfering councillors festered, the Audit Commission said. Councillors got the city into financial problems by setting "unrealistic" budgets, failing to tackle serious housing problems and avoiding making difficult decisions, according to the 78-page report which followed a two-week corporate governance inspection, two months before Labour were overthrown.

There was praise for educational improvements and partnership work which has led to grant-funded regeneration. But on the whole, cash raised from the flotation had not been well spent and the city's housing stock had been badly managed.

"The scale of the problems now facing the council is daunting," the Commission concluded. "The quality of leadership has begun to improve, but it has suffered from in-fighting and has not shaken off a legacy of bullying by some members."

It remained unclear last night whether Nick Raynsford, the Local Government Minister to whom Mr Prescott has delegated the Hull issue to prevent a conflict of interests, will now intervene in the city's affairs. The city's new Lib-Dem leader Simone Butterworth has said she would welcome this.

"Above all this episode demonstrates the need for transparency and quality control," said Mr Jarvis. "It demonstrates to Labour – at every level, town hall to Westminster – that throwing money at problems is not a solution and will not necessarily win votes."

But political lessons were of minimal concern to the people of Hull. Unemployment in the city remains at 6.9 per cent – well above the Yorkshire and Humberside average of 4.1 per cent, two-thirds of households have incomes of less than £15,000 and now the Commission is warning that the city council must cut its budget by 10 per cent (£30m) over the next two years to balance its books.

A headline the city thought it would not seen for years was back on the front page of the Hull Daily Mail yesterday: "Council tax rise is on the cards". The party is over.

Windfall - where the money went

Hull council sold 55 per cent of Kingston Communications, raising £259m. The main spending projects – which have not all yet been completed – were:

* Road and city repairs and improvements. A scheme to improve the city centre has cost £7m, including a sizeable amount on hanging baskets, according to several sources. A total of £37m has gone on mending roads and pavements.

* A "super stadium" costing £32m. Loved by the many rugby devotees but a source of rancour among just as many local people, this will replace the worn-out grounds housing Hull's rugby league and football clubs. Some fear its central location will create traffic problems.

* Central heating and double glazing costing £96m for 25,000 of the city's 38,000 council-owned houses. The expenditure was questioned by the Audit Commission because 3,000 of the homes are empty. But Labour insists the cash was only spent in areas where there is a waiting list.

* Other building repairs. A total of £32m has gone on repairs to council buildings and £35m on fixing schools. Labour claims the quality of school buildings will rival any in Britain when the programme is finished.