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By Les Christie, CNNMoney.com
Last Updated: November 9, 2009: 10:47 AM ET

NEW YORK (CNNMoney.com) -- Fewer people are underwater on their mortgages -- further evidence that the real estate free-fall may be slowing.

Just 21% of all single-family homeowners owe more on their mortgage balances than their homes are worth, according to a third quarter residential real estate report from Zillow.com. That is down from 23% at the end of the second quarter.

That is good news because it should help reduce the number of homeowners losing their homes to foreclosure. Being underwater is one of the two factors that lead to foreclosure, the other being, of course, not having enough income to make the monthly payments.

"The decline in the percentage of homeowners with negative equity is a positive sign and is directly attributable to the stabilization of home values from the second quarter to the third," said Zillow chief economist Stan Humphries.

But there's a second, less-positive factor that contributed to the reduction in underwater borrowers: foreclosures. So many people have already lost their homes that the ranks of those underwater is slowly dwindling.

And that highlights one of the most serious concerns that housing markets currently face. "Foreclosure rates," said Humphries, "are ramping up again."
Upswing

There are 1.2 million to 1.5 million seriously delinquent mortgages sitting out there like ticking time-bombs. These loans are at least 90 days late, and, historically, few borrowers who fall that far behind manage to start repaying.

Aggravating the foreclosure problem is the substantial numbers of option ARM loans that will reset over the next few months. These are loans with balances that have steadily increased because borrowers were permitted to make minimum monthly payments that did not even cover interest.

The resets will require borrowers to start paying down principal, and many will simply not be able to afford to do that.

Also resetting over the next several months will be many interest-only loans, which will also require borrowers to make much larger payments.

Another fear-factor for Humphries is that continued economic malaise will slow the housing market recovery. Recent macro-economic reports have been inconsistent. Good news came early in November, with the gross domestic product, growing at annualized rate of 3.5% during the third quarter.

A couple days later, however, the Labor Department reported the unemployment rate jumped to 10.2% in October. It's an understatement to say that losing a job can make it very difficult to pay off a mortgage.
Ghost hunting

Increased foreclosures also add to already long inventories. The National Association of Realtors reported there are 3.63 million homes on the market, a nearly eight-month supply at the current rates of sales. That's a two or three month oversupply, compared with a normal market.

But official inventory statistics may be undercounting; there is also the so-called "shadow inventory." For one, there are bank repossessions that have not been put back on the market. The banks have either fallen behind on processing these properties or they are reluctant to put REOs up for sale because the market is already overloaded.

The second element of the shadow inventory is that some individual owners would like to sell their homes but do not want to compete with foreclosures, which usually sell at a discount to market values. In many cities, foreclosures and short sales constitute the bulk of the market.

The housing market recovery will be affected by "how quickly these foreclosures transition back onto the marketplace," said Humphries.

Nationally, 21.4% of all sales were REOs, the industry term for bank-owned properties.

High as that rate is, that pales in comparison with some of the worst-hit metro areas. In Merced Calif., for example, 74.2% of all single-family home sales were of foreclosed properties; in nearby Stockton, the rate was 68.7%; and El Centro, down near the Mexican border, the rate was 68.1%.

The good news is that, in many areas at least, foreclosures are selling off quite quickly. The trouble is that, like Alice, who had to run to stay in place in "Through the Looking Glass," REO sales will have to increase at a blistering pace just to keep up with the new inventory coming onto the market.

That could put a damper on home prices for many months to come. To top of page
First Published: November 9, 2009: 10:43 AM ET