Once more all of the financial engineering is coming home to roost. Oh, and the government is caught between banks it wants to save and auto companies it wants to save.

The banks that loaned Chrysler $6.8 billion to facilitate the take over by Cerberus are now balking at the government’s request to exchange $5 billion of their debt for equity. It seems they have a first lien on all of Chrysler’s plant and equipment and figure that this might be worth a lot more than the equity ever will be worth.

From the WSJ:

The lenders, which include J.P. Morgan Chase & Co., Goldman Sachs, Citigroup and Morgan Stanley, hold great influence in moving the process along. As holders of secured debt, they own the rights to take control of Chrysler plants and assets, which were pledged as collateral for the loans, if the company files for bankruptcy protection.

As a result, Chrysler may be worth more to the lenders in liquidation than if they agree to restructure their debt, and the government has little leverage to force them into concessions.

The negotiations show how the government’s involvement in both banks and industrial companies is creating uncomfortable circumstances: The U.S. is directly supporting some of the very banks that are demanding tough terms from Chrysler, also a recipient of government aid.

J.P. Morgan, which has taken the lead in negotiations with the government, has Chrysler debt in the range of $2.5 billion, said a person familiar with the matter. This person said that the other lenders “don’t have quite the same view” as J.P. Morgan on how hard to push the issue of granting concessions.

This person added that all four big banks have had senior people involved in talks with the Treasury the last two days. The bailout money from the Troubled Asset Relief Program these banks received “hasn’t been mentioned, but everyone is aware that issue is there,” said this person.

The article did not mention whether any of these banks had hedged their exposure with derivative products. It would probably be unreasonable to assume they had not. Therefore, there may be a dual reason not to opt to negotiate. Actually, it’s hard to see why they would negotiate this one save for some order pressure from the government.

If nothing else, we may be receiving an object lesson in why central economic planning never has and never will work. Whether we choose to learn the lesson is open to question.