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Underwater insurance, as millions of homeowners emerge for air

Fast-rising home prices brought more borrowers up from underwater in the third quarter of this year than at any time since the housing recovery began. In the quarter, 1.4 million borrowers came into a positive equity position, and nearly 5 million have recovered since the crash.

"We should feel good that we're moving in the right direction, and at a fast clip," said Zillow Chief Economist Stan Humphries.

We are not, however, out of the woods. Twenty-one percent of all homeowners with a mortgage, or nearly 11 million borrowers, still owe more on their loans than their homes are worth, though that is down from a peak of 31 percent early last year, according to Zillow.

And at 39 percent, the "effective" negative equity rate—borrowers who have less than 20 percent equity in their homes—is still staggering. To buy a new house, most homeowners need at least 20 percent equity to pay all the needed expenses, including today's high down payments.

(Read more: Map: Tracking the recovery)

"Negative equity will remain a factor for years to come and must be considered part of the new normal in the housing market," Humphries said. "Short sales will remain a persistent feature of the market as many homeowners remain too far underwater for reasonable price appreciation alone to help."

Peter Gridley | Getty Images

Negative equity has been one of the greatest barriers to a full and robust housing recovery. Sale inventories are painfully low nationwide because so many homeowners don't have the equity to move up (or even down). That lack of listings has depressed sales and pushed prices higher—good for the equity dilemma but bad for potential buyers.

As with all real estate, some markets are suffering more than others. Las Vegas, Atlanta and Orlando, Fla., have the highest negative equity rates, while San Jose, Calif., Denver and San Francisco have seen the biggest drops in negative equity.

The recovery, along with the realization that home prices can in fact fall nationally, has given rise to a new insurance to protect homeowners against negative equity. Underwater Mortgage Protection (UMP), from Kansas-based AmTrust Financial Services, will launch in three states in December and should be available nationwide within a year.

"Our product fills a significant gap that was needed in the marketplace," said Matthew Kayton, vice president of the real estate insurance group at AmTrust. "We will be there to help consumers if they end up in a situation where life happens to them and they need to sell, and they might be in a down market."

For an average monthly premium of $40 to $50, consumers get gap insurance on the value of their home. They must have at least 10 percent equity when they apply for UMP and cannot refinance during the coverage period. If they decide to sell and the house is not worth the mortgage amount, UMP helps sell the property through its own agents and pays the lender the difference. Unlike private mortgage insurance, it protects the consumer rather than the lender.

"The homeowner essentially gets to walk away without the potential negative repercussions of what the old choices were that homeowners had," Kayton said. Those choices consisted of staying in the house, or turning to a short sale or foreclosure.

Critics of UMP say it may be taking advantage of homeowners' fears.

(Read more: Worrisome housing signs appear in West)

"Consumers who have an extra $40 or $50 per month can 'self-insure' against house price declines by paying down their mortgage principal faster," said Barry Zigas, director of housing for the Consumer Federation of America. "This generates further equity and is an investment, not an expense for insurance that may never be recouped."

(Read more: Remodeling? Get Ideas from the neighbors)

The coverage is not designed for high-end homes, Kayton said, adding that $400,000 would be the highest-priced residence AmTrust would insure in most markets.

While UMP is pricey, it may be a price some are willing to pay given everything homeowners have been through in the past five years. Unfortunately it will not help any of the 11 million borrowers still underwater.

By CNBC's Diana Olick. Follow her on Twitter @Diana_Olick.

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.

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