Earlier quoted context omitted.
I guess I do not see how you can lose if you take the contract-to-hire approach I agree with most of what you said, but one way you can lose if you insist on contract-to-hire is that you are filtering out a portion of the highest quality candidates who are only interested in immediate full time hiring.
I don't think many candidates are interested in "immediate" hiring. Most people I know need to take extra time to wait for other offers to come in. It also gives the candidate a way to see what kind of problems he'd be working with, and the quality of the code-base, working conditions, etc. I think it's a win-win.
Quitting a full time job for a new position is a big commitment on my part, and I'd like a big commitment on the other side of the table. Not to mention contracting gigs don't usually have insurance, vacation, or other benefits.
If it means a more rigorous interview that's okay with me.