No equity in the house, we owe more than what the house is worth. A septic tank system needs to be replaced, estimate is in the thousands of dollars which I don't have the money to pay out. Moving to another state due to job being eliminated. I can't pay for an apt and a house at the same time. Two mortgages. Will sending a letter of explanation of our circumstances help, and how would a Deed in Lieu be considered by the 2nd mortagage company if we considered a Short Sale? Actually, could a Short Sale even take place with the disclosure about the septic system?

Whether a short sale will be allowed depends on the lenders. Same thing with a Deed in lieu, which is even less likely since lenders don't want your property, they just want their money back.

Your best bet is to do anything you can to either sell or rent the place. If a foreclosure has to happen, then you just ride it out.