As is typical in leveraged buyouts, the banks planned to unload the debt rather than hold it on their books, but a decline in markets since April means that if they did so now they would be on the hook for losses that could run into the hundreds of millions, according to people familiar with the matter.

Banks are presently looking at an estimated $500 million in losses if they tried to unload all the debt to third-party investors, according to 9fin, a leveraged-finance analytics firm.

Representatives of Mr. Musk and Twitter had been trying to hash out terms of a settlement that would enable the stalled deal to proceed, grappling with issues including whether it would be contingent on Mr. Musk receiving the necessary debt financing, as he is now requesting. On Thursday, a judge put an impending trial over the deal on hold, effectively ending those talks and giving Mr. Musk until Oct. 28 to close the transaction.

The debt package includes $6.5 billion in term loans, a $500 million revolving line of credit, $3 billion in secured bonds and $3 billion in unsecured bonds, according to public disclosures. To pay for the deal, Mr. Musk also needs to come up with roughly $34 billion in equity. To help with that, he received commitment letters in May for over $7 billion in financing from 19 investors including

Oracle Corp.

co-founder and

Tesla Inc.

then-board member

Larry Ellison

and venture firm Sequoia Capital Fund LP.

The Twitter debt would be the latest to hit the market while high-yield credit is effectively unavailable to many borrowers, as buyers of corporate debt are demanding better terms and bargain prices over concerns about an economic slowdown.

That has dealt a significant blow to a business that represents an important source of revenue for Wall Street banks and has already suffered more than $1 billion in collective losses this year.

The biggest chunk of that came last month, when banks including Bank of America,

Goldman Sachs Group Inc.

and

Credit Suisse Group AG

sold debt associated with the $16.5 billion leveraged buyout of Citrix Systems Inc. Banks collectively lost more than $500 million on the purchase, the Journal reported.

Banks had to buy around $6 billion of Citrix’s debt themselves after it became clear that investors’ interest in the total debt package was muted.

“The recent Citrix deal suggests the market would struggle to digest the billions of loans and bonds contemplated by the original Twitter financing plan,” said Steven Hunter, chief executive at 9fin.

People familiar with Twitter’s debt-financing package said the banks built “flex” into the deal, which can help them reduce their losses. It enables them to raise the interest rates on the debt, meaning the company would be on the hook for higher interest costs, to try to attract more investors to buy it.

However, that flex is usually capped, and if investors still aren’t interested in the debt at higher interest rates, banks could eventually have to sell at a discount and absorb losses, or choose to hold the borrowings on their books.

The leveraged loans and bonds for Twitter are part of $46 billion of debt still waiting to be split up and sold by banks for buyout deals, according to Goldman data. That includes debt associated with deals including the roughly $16 billion purchase of

Nielsen Holdings

PLC, the $7 billion acquisition of automotive-products company

Tenneco

and the $8.6 billion takeover of media company

Tegna Inc.

Private-equity firms rely on leveraged loans and high-yield bonds to help pay for their largest deals. Banks generally parcel out leveraged loans to institutional investors such as mutual funds and collateralized-loan-obligation managers.

When banks can’t sell debt, that usually winds up costing them even if they choose not to sell at a loss. Holding loans and bonds can force them to add more regulatory capital to protect their balance sheets and limit the credit banks are willing to provide to others.

In past downturns, losses from leveraged finance have led to layoffs, and banks took years to rebuild their high-yield departments. Leveraged-loan and high-yield-bond volumes plummeted after the 2008 financial crisis as banks weren’t willing to add on more risk.

Indeed, many of Wall Street’s major banks are expected to trim the ranks of their leveraged-finance groups in the coming months, according to people familiar with the matter.

Still, experts say that banks look much better positioned to weather a downturn now, thanks to postcrisis regulations requiring more capital on balance sheets and better liquidity.

“Overall, the level of risk within the banking system now is just not the same as it was pre-financial crisis,” said Greg Hertrich, head of U.S. depository strategy at Nomura.

Last year was a banner year for private-equity deal making, with some $146 billion of loans issued for buyouts—the most since 2007.

However, continued losses from deals such as Citrix and potentially Twitter may continue to cool bank lending for M&A, as well as for companies that have low credit ratings in general.

“There’s going to be a period of risk aversion as the industry thinks through what are acceptable terms for new deals,” said Richard Ramsden, an analyst at Goldman covering the banking industry. “Until there’s clarity over that, there won’t be many new debt commitments.”

—Cara Lombardo contributed to this article.

Write to Alexander Saeedy at alexander.saeedy@wsj.com, Laura Cooper at laura.cooper@wsj.com and Ben Dummett at ben.dummett@wsj.com