"While the housing market continues to face some weakness, the recent correction in MBS prices has been more severe than justified by underlying real estate market fundamentals," Paulson said in an October investor letter, a copy of which was obtained by Bloomberg News. "This creates an opportunity to benefit from very attractive yields on both" residential and commercial mortgage securities.
His credit funds owned at least $2.4 billion of mortgage- backed securities on a "notional" basis in the third quarter, or at least 20 percent of its holdings, according to data in the letter. Notional typically refers to the face value of bonds or bets in derivative markets.
Paulson is persisting with the wager, according to a person with knowledge of the fund, who asked not to be named because the information is private. A spokesman for the $28 billion hedge fund in New York declined to comment.
Paulson's Advantage Plus fund, one of his largest, slumped 51 percent last year as bets on a U.S. economic recovery backfired and banks declined. The fund had lost 46 percent through the end of September.
Tom Sontag, a money manager in Chicago at Neuberger Berman, which oversees about $183 billion in assets, added non-agency securities to some of his portfolios in late November and December, focusing on subprime bonds.
"The sector is one of the most attractive out there," he said. The market fell more than other securities for "specific technical factors" such as the Fed's auctions and regulatory changes that will boost how much capital dealers will need to hold against low-rated debt, which spurred sales, he said.
Top-ranked subprime-mortgage bonds from 2005 through 2007, the years with the worst loans, declined 8.8 percent on average from March through October, according to a Barclays Capital index. Some lost 21 percent in 2011, JPMorgan Chase & Co. estimates.
Subprime bonds, which gained 25.6 percent in 2010, returned 1 percent since the end of October, Barclays data show. Typical prices of top-ranked securities tied to so-called Alt-A adjustable-rate loans were unchanged in the month ended Jan. 4, after falling to 48 cents on the dollar from 68 cents in February.
Paulson referred to prices on Alt-A debt, which falls between prime and subprime, in his October letter.
More than 28 percent of home loans underlying non-agency securities are at least 60 days delinquent, near the record 30.2 percent reached in March 2010, according to data compiled by Bloomberg, after loan servicers slowed liquidations in response to foreclosure-document errors and new defaults eased. First- time defaults fell last month to an annual pace of 9.8 percent, from 12 percent a year earlier, Amherst Securities Group LP data show. Improvement since early 2009, when the rate exceeded 25 percent, is slowing as unemployment remains elevated.