SAN FRANCISCO (MarketWatch) -- Paulson & Co., a $24 billion hedge fund firm that's generated huge returns from betting against subprime mortgage securities, has begun trimming those positions.
Still, the firm reckons turmoil in credit markets isn't over and has been taking more derivative bets against financial-services firms that it thinks are vulnerable, according to a letter Paulson sent to investors recently. MarketWatch obtained a copy of the letter on Thursday.
Paulson began betting against subprime mortgage securities last year. As delinquencies and foreclosures surged this year, some of those securities have slumped as rating agencies downgraded them.
That helped the Paulson Credit Opportunities Ltd. fund return 117%, net of fees, during the third quarter. That leaves the fund up more than five-fold for the first nine months of 2007, according to the letter.
As the subprime mortgage problem deepened into a global credit crisis in the third quarter, Paulson began closing some of its negative bets, locking in some of the gains from those positions.
"We took advantage of market conditions to selectively realize gains," the firm wrote in its letter to investors.
Paulson isn't the only hedge fund firm trimming subprime bets. Scion Capital, a $621 million firm run by Michael Burry, began unwinding similar trades recently. See full story.
It's not over yet
Still, Paulson also stressed that while the subprime correction is well underway, the housing market in general and other parts of credit markets are still set to deteriorate further.
Home prices have fallen 3% in the U.S. so far, but Paulson reckons there could be a 15% to 25% drop in prices from their peak.
Most of Paulson's remaining subprime mortgage positions will likely be written off as losses on these securities keep rising, the firm added, noting that it bet against the lowest-rated, riskiest parts.
Cumulative losses of 6.25%, on average, would wipe out these securities, but losses on such securities sold in 2006 could end up being at least twice that, which will wipe out higher-rated parts of these structures, Paulson explained.
Corporate debt bet
Other parts of credit markets remain vulnerable, Paulson said.
The firm has researched "dozens" of financial-services institutions and has been betting against these companies through credit default swaps. (CDS are a bit like insurance against a company defaulting. The buyer of protection, such as Paulson, is betting that companies' ability to repay their debts deteriorates).
"We believe the opportunity is similar, though not as great, as when we started buying protection on subprime well ahead of actual recognition of the problem," Paulson wrote. "We do not feel that the credit correction is over."
$15 million donation
Paulson also told investors that its funds are donating $15 million to provide initial funding for the Institute for Foreclosure Legal Assistance, a new non-profit formed by the Center for Responsible Lending.
The new group will be managed by the National Association of Consumer Advocates and will provide legal help to subprime homeowners facing foreclosure.
"Given the success of our funds, we feel it is important to help those who have suffered the most as a result of predatory subprime lending practices," Paulson wrote. 
Alistair Barr is a reporter for MarketWatch in San Francisco.
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