Housing Recovery Depends on Slashing Mortgage Debt

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Rising home prices are the foundation of today's housing recovery. They are drawing much-needed buyers back to the market. Prices would not be rising if the number of foreclosures wasn't falling. They also wouldn't be rising without underwater borrowers getting a break from their banks. Both of those are happening because banks are slashing the balances of thousands of mortgages and letting homeowners sell for less than the value of their loans rather than going to foreclosure.

That debt forgiveness is currently not taxable, thanks to a law passed five years ago which expires at the end of this year. There is bipartisan support to extend that law, but so far any action has been mired in stickier negotiations surrounding the so-called "fiscal cliff."

(Read More: Mortgage Deduction Is Popular, but Few Claim It)

"The prospect of being taxed on potentially tens or hundreds of thousands of dollars in additional income may motivate more distressed homeowners to forgo a short sale and allow the home to be foreclosed," said RealtyTrac's Daren Blomquist in a release. "Additionally, if the mortgage interest deduction is eliminated due to the fiscal cliff quagmire, it would give many underwater and otherwise distressed homeowners one less reason to hang on to their homes."

Banks completed 13,351 principal reduction loan modifications in November alone, according to a monthly report from Amherst Securities Group. That's a 62 percent jump from September. Much of it is thanks to the $25 billion mortgage servicing settlement signed by the nation's five largest banks early this year over so-called "robo-signing" foreclosure practices.

Banks have already given borrowers $6.3 billion in mortgage principal relief under the settlement, according to a report from its monitor, Joseph A. Smith, released last month. Bank of America recently ramped-up its relief, reporting 30,000 customers were approved or had completed first-lien modifications through September 30 providing $4.75 billion in principal reduction. Borrowers received an average $150,000 slash in loan balances.

(Read More: How 'Fiscal Cliff' Could Affect Mortgage Interest Deduction)

Short sales, another form of principal forgiveness, are also surging. 98,125 homes were sold for less than the value of the mortgage during the third quarter of this year, according to a new report from RealtyTrac. Short sales of properties not facing foreclosure also jumped 15 percent from the previous quarter.

Why is this key to prices?

For one, properties in a short sale garner far higher prices than comparable homes that have been through foreclosure and are bank-owned. Short sales can still lower the value of homes around them, but not nearly as badly as foreclosures.

Principal reduction loan modifications help to stabilize home prices because they bring underwater borrowers into or closer to a positive equity position, drastically reducing the probability of a loan default and ultimate foreclosure. Principal reduction loan modifications have a far lower re-default rate than modifications that just extend the term of the loan or lower the interest rate.

During a Senate Banking Committee hearing Thursday, Secretary of Housing and Urban Development Shaun Donovan told the panel that extending tax relief on debt forgiveness is "a high priority," but could make no promises.

(Read More: Amid 'Fiscal Cliff' Stalemate, Main Street Deteriorates)

—By CNBC's Diana Olick; Follow her on Twitter @Diana_Olick or on Facebook at facebook.com/DianaOlickCNBC

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