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After pointing a gun to the head of Congress and threatening a financial meltdown in case his plan was not approved, U.S. Treasury Secretary Hank Paulson has finally arrived at the only logical conclusion: His original plan to buy distressed assets will not work.

Desperate for a Plan B, Paulson is embracing the suggestion of many economists: Inject some equity into the financial system by directly buying shares in banks. Unfortunately, the secretary’s move is too little, too late. The confidence crisis is so severe that only a massive infusion of equity capital can reassure the markets that the major banks will not fail, re-creating the confidence for banks to lend to each other.

The piecemeal approach of $100 billion today, $100 billion tomorrow used with insurer AIG will not work. It will only eat up tens of billions in taxpayer money without achieving the desired effect—reassuring the markets that the worst is over.

Simply stated, nothing short of a 5 percent increase in the equity capital of the banking system will do the trick. We are talking about $600 billion. But even if the government is willing to spend this kind of money, three problems remain.

First, to restore the necessary confidence, a capital infusion needs to reduce financial institutions’ risk of default to trivial levels. This implies transforming their existing, outstanding debt (roughly $2 trillion if we just count the long-term bonds) into safe debt. A large fraction of the equity injected will not go to generate new loans, but to provide this insurance to existing debt holders. How much? We can estimate it by looking at the credit default swaps, a form of contract insurance that provides us with the cost of insuring the debt against default. At current prices, the cost of insuring the $2 trillion of outstanding long-term bonds would be more than $300 billion. Consequently, at least half the capital the government will invest in banks will not go to increase new loans, but to bail out Wall Street investors.

Second, a capital infusion does not address the root of the problem: the housing market. If homeowners continue to default and walk away from their houses, the banking sector will continue to bleed. Meanwhile, the animosity the bailout plan generates will induce more homeowners to walk away from their mortgages. Many of them will think, “Why do I have to play by the rules when Wall Street does not?”

This leads us to the third and most important problem. If we bail out Wall Street, why not bail out Detroit (probably another $150 billion) and Main Street? In fact, presidential candidate Sen. John McCain has already talked about buying out the defaulted mortgages to keep people in their homes. Even if we limit ourselves to subprime mortgages, that’s $1.3 trillion. Where does it stop?

We need a different solution: a Plan B. A plan that minimizes the money the government uses in bailing out Wall Street and Main Street to save our precious dollars for a stimulus package, which will be essential to restarting the economy.

Rescuing Main Street

Suppose you bought a house in California in 2006. You paid $400,000 with only 5 percent down. Unfortunately, during the last two years the value of your house dropped 30 percent. So, you now find yourself with a mortgage worth $380,000 and a house worth $280,000. Even if you can afford your monthly payment (and you probably cannot), why should you struggle to pay the mortgage when walking away will save you $100,000, more than most people can save in a lifetime?

However, when the homeowner walks away, the mortgage holder does not recover $280,000. The foreclosure process takes some time, during which the house is not properly maintained and further deteriorates in value. The recovery rate in standard mortgage foreclosures is 50 cents per dollar of the mortgage. Given today’s conditions, 37 percent is probably a safer estimate, meaning that a house with a $380,000 mortgage is worth only $140,000 to its holder.

Foreclosure, in other words, is costly for both borrower and lender. In the old days, when the mortgage was granted by your local bank, there was a simple solution to this tremendous inefficiency: The bank forgave part of your mortgage, say, 30 percent. This creates a small positive equity value—an incentive—for you to stay. Because you stay and maintain the house, the bank gets its $266,000 dollars of the new debt back, which beats the $140,000 it would get through foreclosure.

Unfortunately, this win-win solution is not possible today. Your mortgage has been sold and repackaged in an asset-backed security pool and sold in tranches with different priorities. There is disagreement on who has the right to renegotiate, and renegotiation might require the agreement of at least 60 percent of the debt holders, spread throughout the globe. Furthermore, unlike your local bank, distant debt holders have little idea whether you are a good borrower who has been unlucky or somebody just trying to take advantage of the lender.