The shadow inventory of homes likely to be sold after foreclosure declined by 35% since the peak reached two years ago, according to Morgan Stanley (MS) researchers.

There are roughly 5.65 million properties in this backlog now, down from 8.79 million at the beginning of 2010. These homes are either already foreclosed and not yet for sale, or they back delinquent mortgages that will likely need to be liquidated. The weight of these properties drags down home prices and resists recovery in the hardest hit areas (click on graph below to expand).

Shadow inventory estimates vary, usually based on what stage of delinquency is considered. CoreLogic (CLGX) for example estimates a 1.5 million backlog, because it considers only severely delinquent home loans. The analytics firm also said the inventory is on the decline.

Morgan Stanley researchers said they use earlier delinquencies to better track the effects modifications and short sales are having. Servicers are getting better at modifying troubled home loans and investor demand for already repossessed property is on the rise, allowing the inventory to shrink, researchers said.

"This is clearly good news, not only for distressed houses but also for the housing market as a whole," according to the Morgan Stanley report.

Still, more than half of the shadow inventory contains mortgages that have been delinquent for more than one year, and progress reducing it varies across the country.

Out West, the shadow inventory shrank by 52% since its peak in February 2010. In the South and Midwest, it declined by 33%. And the inventory dropped 17% in the Northeast.

Judicial states where the foreclosure process is handled by courts showed the slowest declines as mortgage servicers still had to repair broken processes and steep backlogs. The result has been a rocky up-and-down change in the shadow inventory.

In non-judicial states, however, the inventory declined every month since the start of last year but one (click on graph below to expand).

Foreclosures are restarting in many areas, but servicers have used more short sales than REO every month since September to steer these properties away from the backlog, according to the report.

Given the progress, many investors have been betting once again on private-label mortgage bonds. Given the decline in the shadow inventory could allow them to lower expectations for future losses even further.

"Some of this may already be happening," researchers said.