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‘Underwater’ Mortgages Decline, but Housing Is Still Hurting

The number of homeowners "underwater" on their mortgages fell in the second quarter, according to a new report by the online real estate firm Zillow, but these mortgages are still a drag on the housing market.

Peter Gridley | Getty Images

Underwater mortgages, where the homeowner owes more than their home is worth, dropped to 15.3 million from 15.7 million in the first quarter, Zillow reported.

The drop is an encouraging sign but the problems are still very real for homeowners. Without equity in their homes, people get stuck.

"Negative equity is trapping young people in their homes, preventing them from selling," said Zillow Chief Economist Stan Humphries. "These homes are likely the very starter homes potential first-time homebuyers are seeking." (Read More: Banks Pushed to Outsource Mortgages.)

Job loss, divorce or other hardships can quickly push people into foreclosure. Zillow found that the negative equity situation is the worst among borrowers under the age of 40, with nearly half of them underwater.

Even as the negative equity situation improved this quarter, it’s most acute in the places hardest hit by the housing crash.

Phoenix and Miami-Ft. Lauderdale showed the most improvement, but Phoenix still has more than half its borrowers in negative equity (going from 55.5 percent in the first quarter to 51.6 percent in the second). Miami has 43 percent of borrowers in negative equity (down from 46.4 percent). Las Vegas metro leads the pack with the highest rate: More than 68 percent of borrowers there are underwater (down from 71 percent). (Read More: Emptiest US Cities.)

The Federal Housing Finance Agency ruled out principal reductions as a way to address the problem, but is now moving to open up short sales for more borrowers.

Under new guidelines effective Nov. 1, Fannie Mae and Freddie Mac will make it easier for mortgage servicers to approve short sales. (Read More: 'Wind Down' of Fannie, Freddie: 'Positing for Housing?')

Borrowers no longer will have to be behind on their payments to qualify if they face a hardship like the death of a co-borrower, divorce, illness or a job transfer. No hardship will be needed if a borrower is more than 90 days late on the mortgage payment.

The new rules also try to get second-lien investors to go along by putting a $6,000 cap on payment they can receive, from what now is a negotiated amount.

National Association of Realtors economist Lawrence Yun said the rules should speed up the process from what can now take six months, “with the new rules you will make it much easier to complete the short sale.” (Read More: Cities With the Most Affordable Homes.)

Short sales are one way more borrowers can escape negative equity. That’s a positive for housing, according to a Morgan Stanley in a research report.

“Short sales allow shadow inventory to be cleared in a manner that supports neighborhood preservation by preventing properties from falling into disrepair through non-occupancy, abuse and abandonment,” wrote Morgan Stanley's Vishwanath Tiruppattur.

But the short sale relief could be short-lived.

Borrowers have been exempt from paying taxes on debt forgiven in a sale since the Mortgage Act Relief Act of 2007. The tax break is set to expire at the end of this year.

—By CNBC's Stephanie Dhue; Follow Her on Twitter @StephanieDhue

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