SAN FRANCISCO (MarketWatch) -- Two hedge fund firms that racked up huge gains betting on the subprime mortgage meltdown have begun winding down those trades and looking elsewhere. They're now betting against corporate debt using derivatives.

Paulson & Co. has generated returns of up to 435% in the first nine months of 2007 thanks to short positions on securities backed by subprime home loans, according to an update the $24 billion hedge fund firm sent to investors recently. Short sales rise in value when the securities in question fall.

Scion Capital LLC, $621 million hedge fund firm run by Michael Burry, reported gains of between 78% and 85%, after fees, during the first nine months of this year from similar bets.

As rising delinquencies on subprime mortgages escalated into a global credit crisis this summer, some in the $1.8 trillion hedge fund industry thrived, like Paulson and Scion, while others fell. Sowood Capital Management and two funds run by Bear Stearns BSC, -10.00% , collapsed.

After being among the first to spot problems in the subprime mortgage business, Paulson and Scion may now be among the first to begin closing negative bets, even as credit market turmoil continues.

"The correction in the subprime market is well under way," John Paulson, the former Bear investment banker who runs Paulson & Co., wrote in a letter to investors. "We took advantage of market conditions to selectively realized gains."

Silicon Valley-based Scion had $1.7 billion worth of short positions on parts of subprime mortgage securities at the start of 2007. By mid-October, those short positions had been whittled down to $479 million, according to a letter Burry sent to investors this month. MarketWatch obtained copies of both letters.

"The opportunity in 2005 and 2006 to short subprime mortgages was an historic one," Burry wrote. "With continued hard work and a bit of luck, we will latch onto another opportunity like the subprime short. But I am not counting on it happening anytime soon."

It's not over yet

Still, both Paulson and Burry said the credit crisis is far from over.

The housing market will likely deteriorate further, Paulson predicted. Home prices have fallen 3% in the U.S. so far, but he 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, he added, noting that his firm 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 bets

Other parts of credit markets also 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."

Scion's Burry also has a derivative bet against corporate debt that's worth roughly $2.2 billion, he noted in his letter to investors. That could still generate big gains if there's more turmoil in credit markets, he said.