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) -- Short sales activity declined sharply in the first quarter, a sign that banks may be re-evaluating their strategy for resolving troubled mortgages amid rising home prices.

According to the latest

Foreclosure & Short Sales report

from RealtyTrac, non-foreclosure short sales fell 10% from the fourth quarter of 2012 and were down 35% from a year earlier.

This marks a shift from a trend of increasing short sales over the past two years.

In a typical short sale, a bank allows an underwater borrower behind on his mortgage loan payments to sell his home for less than the amount owed and generally forgives the remaining balance on the mortgage.

The short sale process has been touted as a better alternative to foreclosure, which has proved to be a time-consuming, costly and onerous process for banks.

Also see: Texas Home Prices Hit New Highs, LPS Says >>

Borrowers have also preferred short sales over foreclosures as it allows them time to adjust to their new circumstances and find alternative accommodations. Short sales are also thought to be less damaging to borrower credit scores, although the borrowers will likely have to wait before applying for a new mortgage.

For the more than 10 million homeowners who still owe more than their homes are worth, several million of whom are at high risk of default, short sales may still make sense.

Still, the increase in home prices is likely changing the equation for borrowers and banks. "Rising home prices in many markets are stunting the continued growth of short sales by reducing incentive for both underwater homeowners and lenders," according to RealtyTrac Vice President Daren Blomquist. "Underwater homeowners may be willing to stick it out a few more months or even years in the hope that they will be able to walk away with money at the closing table and without a hit to their credit rating, and for lenders a failed short sale may no longer translate into bigger losses down the road given that average prices of bank-owned homes are rising -- at a faster pace than non-distressed home prices in many markets."

Another factor may also be at play. Big banks including

Bank of America

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JPMorgan Chase

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Wells Fargo

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have been ramping up short sales in order to fulfill their obligations under the $25 billion national mortgage settlement struck with federal regulators last year.

The settlement requires banks to offer various forms of mortgage relief including principal reductions, short sales, deeds in lieu of foreclosure and refinancing.

Also see: Fannie, Freddie Retreat After Historic Gains >>

According to the latest report from the settlement oversight monitor, 175,187 borrowers had either a short sale or a deed in lieu of foreclosure completed over the past year, with banks forgiving the unpaid principal. The total amount of relief from short sales totaled more than $20 billion. In total, consumers have received some form of mortgage relief under the settlement to the tune of $50 billion.

Banks do not get full credit for every dollar of short sales they complete under the settlement. But given that the settlement calls for about $25 billion in relief in total, banks may have reason to believe they have fulfilled a good chunk of their obligations. They may lack the incentive to do as many short sales this year, according to Blomquist, which could explain the sudden decline in the first quarter.

Meanwhile, foreclosure activity is also on the decline. There were 190,121 bank sales of repossessed properties or properties in some stage of foreclosure during the quarter, down 18% from fourth quarter and 22% from the first quarter of 2012.

Foreclosures have been declining on the back of increasing use of short sales, lower defaults and the fact that banks are still adjusting to newly enacted servicing laws in various states.

Also see: Fannie and Freddie Vultures Need a Facelift >>

Still, the default rate remains elevated, with the percentage of mortgages more than 30 days past due but not in foreclosure at 6.21% according to LPS.

That suggests foreclosures and short sales will likely remain elevated. The high re-default rate on loan modifications and the prolonged foreclosure process also suggest that short sales will remain the most likely alternative for banks.

Also see: Banks Set Record of $40.3B in Earnings >>

-- Written by Shanthi Bharatwaj in New York.

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