Leading investment banks have dramatically expanded their lending to leveraged buy-outs in recent months, increasing their potential exposure to a bursting of the “credit bubble”.

Goldman Sachs’ commitments to extend credit to non-investment grade companies soared by 60 per cent to $29.5bn in the six months to May 31, according to its latest filing with the Securities and Exchange Commission.

Morgan Stanley’s leveraged commitments reached $8.2bn, up almost 50 per cent.

Other investment banks have also stepped up lending to the wave of buy-outs. Two weeks ago, UBS jointly arranged a debt package of more than $3.5bn for Blackstone’s acquisition of Cendant’s Travelport, its largest US leveraged buy-out commitment.

Bankers say the trend reflects the increasing importance of private equity firms as generators of investment banking fees and the banks’ willingness to take on risk to compete with commercial banks’ big balance sheets.

“You want to get in at the start of a buy-out because you are then in a strong position to pick up other work such as the IPO,” said the head of high-yield finance at one Wall Street bank.

The investment banks’ push also reflects the increasing depth and breadth of the capital markets, which allows them to sell on loans. However, private equity firms like their banks to retain a portion, although they can often hedge some exposure.

Moreover, to win business, banks are increasingly agreeing to go without “material adverse change” clauses that allow them to renegotiate financing if there is a big change in market conditions or the borrower’s business.

“There is no doubt these deals are getting riskier, and [soon] we’ll see how careful the investment banks have been,” said a senior executive at a leading commercial bank.

Observers are predicting a sharp increase in defaults among highly leveraged companies, while the debt markets are likely to get more difficult.

The biggest providers of syndicated leveraged loans are the US commercial banks – JPMorgan Chase, Bank of America and Citigroup – followed by Deutsche Bank and Credit Suisse. But Goldman jumped to sixth place this year, according to Dealogic.

Lehman Brothers, the leading provider among US investment banks in recent years, had net credit exposure to non-investment grade borrowers after hedges of $5.6bn at May 31, double last year’s figure.

In its filing, Goldman notes that its non-investment grade lending commitments of $29.5bn at May 31 may be reduced by syndication, are often replaced by borrowers with other funding sources, and may expire unused.

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