NEW YORK (MainStreet) — First the good news, then the bad.

The number of underwater homeowners – those who owe more on their mortgage than their property is worth – declined for the third straight quarter, according to a new report from CoreLogic, a research firm.

There were 10.8 million underwater homes at the end of the third quarter this year, down from 11 million at the end of the previous quarter. In total for the first three quarters of 2010, CoreLogic reports 500,000 fewer homes with negative equity, though the 10.8 million that remain represent 22.5% of all properties in the U.S.

While this data set may provide some hope that the housing market is beginning to improve, it comes with one major caveat. During this time period, as the number of underwater homes decreased, the number of foreclosed properties increased.

A separate report from RealtyTrac estimates that there will be 1.2 million foreclosures by the end of 2010, an increase of about 300,000 from 2009, which offsets much of the reduction in underwater homes. Indeed, the states that CoreLogic found to have the biggest drop in underwater properties – Nevada, Arizona and Florida – also posted the highest foreclosure rates during this time period.

To put it bluntly, a big part of the reason that fewer homes are underwater now seems to be that banks have ramped up foreclosure proceedings against homeowners who have fallen too far behind on their mortgages, rather than working with them to renegotiate the terms of their loan.

The cause of this disturbing trend seems to rest with lenders as much as with the government.

According to the Congressional Oversight Panel, which released a report Tuesday reviewing the government’s mortgage modification program, lenders have “repeatedly lost borrower paperwork or refused to perform loan modifications,” opting instead to pursue foreclosures.

At the same time, the Treasury Department has failed to hold lenders accountable for their refusal to pursue alternatives to foreclosures. As a result, the panel estimates that government will only be able to prevent about 300,000 foreclosures from happening, compared to the program’s initial goal of stopping up to 4 million foreclosures.

But as disruptive as foreclosure is to a homeowner’s lifestyle, there is a kind of tough justice to this system. The housing market is, quite literally, purging itself of its most rotten apples. Prior to the recession, banks promoted and approved mortgages they never should have, and families have had great difficulty ever since trying to keep up with payments.

In fact, one striking statistic in CoreLogic’s report is that more than 2 million homeowners are currently in danger of having their properties go underwater as housing prices around the country continue to decline. Not only is this potentially debilitating to those millions of homeowners, but it can also imperil the overall housing market.

"Negative equity is a primary factor holding back the housing market and broader economy,” said Mark Fleming, chief economist with CoreLogic. “The good news is that negative equity is slowly declining, but the bad news is that price declines are accelerating, which may put a stop to or reverse the recent improvement in negative equity.”

So in a larger sense, it’s good that banks are being critical of underwater homes now, since there will only be more later, which would further destabilize the market. The problem is not that foreclosures are increasing, but rather that incidents of inappropriate foreclosure procedures are increasing, as banks attempt to fast-track the paperwork.

But putting aside this controversy, the health of the housing market has shown some signs of improvement.

According to a recent report from TransUnion, mortgage delinquency rates are expected to drop by double digits next year as more homeowners begin to catch up on their payments. Of course, this brighter future only comes after some 4 million to 5 million households with delinquent mortgages are foreclosed on.

Ultimately, the big takeaway from CoreLogic’s report is the stark reminder that much of the good news we hear in these post-recession days actually conceals some bad news behind it. Yes, statistics show that Americans are starting to catch up on their mortgage payments and get their houses in order, but only after banks have weeded out millions of weaker properties.

In the same way, statistics show that consumers are increasingLY paying back their credit card debt, but only after many consumers charged off their excess debt, and ruined their credit rating, all to get a fresh start.

The sad truth is that things really do have to get worse in order to improve.

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