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.

Here is where government intervention can help. Instead of pouring money to either side, the government should provide a standardized way to renegotiate, one that is both fast and fair.

Congress should pass a law that makes a recontracting option available to all homeowners living in a ZIP code where house prices dropped by more than 20 percent since the time they bought their property. Why? Because there is no reason to give a break to inhabitants of Charlotte, North Carolina, where house prices have risen 4 percent in the last two years.

How do we implement this? We have reliable measures of house price changes at the ZIP code level, thanks to two brilliant economists, Chip Case and Robert Shiller. By using the Case-Shiller real estate index, the recontracting option will reduce the face value of a mortgage (and the corresponding interest payments) by the same percentage by which house prices have declined since the homeowner bought (or refinanced) his property—exactly like in my hypothetical example above.

In exchange, however, the mortgage holder gets some of the equity value of the house at the time it is sold. Here’s how it works: At the time of sale, the owner pays 50 percent of the difference between the selling price and the new value of the mortgage back to the mortgage holder. Stanford University successfully implemented a similar arrangement for its faculty, financing part of the house purchase in exchange for a fraction of the appreciation value at the time of sale.

The reason for this sharing of the benefits is twofold. First, it makes the renegotiation less appealing to homeowners, making it unattractive to those who don’t need it. For example, homeowners with a very large equity in their house (who do not need any restructuring because they are not at risk of default) will find it very costly to use this option because they will have to give up half the value of their equity. Second, it reduces the cost of renegotiation for the lending institutions, which minimizes the problems in the financial system.

The great benefit of this program is that it provides relief to distressed homeowners at no cost to the federal government and at the minimum possible cost for the mortgage holders. It will stop defaults on mortgages, eliminating the flood of houses on the market and thus reducing the downside pressure on real estate prices. By stabilizing the real estate market, this plan can help prevent further deterioration of financial institutions’ balance sheets. But it will not resolve the problem of severe undercapitalization that these institutions are currently facing. For this, we need the second part of the plan.

Rescuing Wall Street

The plan for Wall Street follows the same general concept: facilitating an efficient renegotiation. The key difference between the Main Street and Wall Street plans is in the ease of assessing the current value of the troubled assets. It is relatively easy to estimate the current value of a house by looking at the purchase price and at the intervening drop in value (per the Case-Shiller index). But for the complex assets based on the mortgage for that house? It’s much harder. Instead, we are going to use a clever mechanism invented 20 years ago by a lawyer and economist named Lucian Bebchuk.

The core idea is to have Congress pass a law that sets up a form of prepackaged bankruptcy to allow banks to restructure their debt and restart lending. Prepackaged means that all the terms are prespecified and banks could come out of it overnight. All that would be required is a signature from a federal judge. Unlike in the private sector, where the terms are generally agreed upon by the parties involved, the innovation here would be to have all the terms preset by the government, thereby speeding up the process. Firms that enter into this special bankruptcy would have their old equity holders wiped out and their existing debt (commercial paper and bonds) transformed into equity.

This would immediately make banks solid, by providing a large equity buffer. As it stands now, banks have lost so much in junk mortgages that the value of their equity has tumbled nearly to zero. They are close to being insolvent. By transforming all banks’ debt into equity, this special Chapter 11 would make banks solvent and ready to lend again.

Some current shareholders might disagree that their bank is insolvent and would feel cheated by a proceeding that wipes them out. Here’s where the Bebchuk mechanism comes in handy. After the filing of the special bankruptcy, we give these shareholders one week to buy out the old debt holders by paying them the face value of the debt. Each shareholder can decide individually: If he thinks the company is solvent, he pays his share of debt and regains his share of equity. Otherwise, he lets it go.

My plan would exempt individual depositors, who are federally insured. I would also exempt credit default swaps and repo contracts to avoid potential ripple effects through the system (à la Lehman Brothers). Banks that enter this special bankruptcy code would not be considered in default as far as their contracts are concerned.

How would the government induce insolvent banks (and only those) to voluntarily participate? One way is to harness the power of short-term debt. By involving the short-term debt in the restructuring, this special bankruptcy will engender fear in short-term creditors. If they think the institution might be insolvent, they will pull their money out as soon as they can for fear of being involved in this restructuring. In so doing, they will generate a liquidity crisis that will force these institutions into this special bankruptcy.

An alternative mechanism is to have the Federal Reserve limit access to liquidity. Both banks and investment banks currently can go to the Fed’s discount window, meaning that they can, by posting collateral, receive cash at a reasonable rate of interest. Under my plan, for the next two years only banks that underwent this special form of bankruptcy would get access to the discount window. In this way, solid financial institutions that do not need liquidity are not forced to undergo this restructuring, while insolvent ones would rush into it to avoid a government takeover. To prevent a dumping of shares that would have a negative effect on market prices, institutions that are restricted from holding equity should be given two years to comply.

The beauty of this approach is threefold. First, it recapitalizes the banking sector at no cost to taxpayers. Second, it keeps the government out of the ugly business of establishing the price of distressed assets. If debt is converted into equity, its total value would not change, only the legal nature of the claim would. Third, this plan removes the possibility of the government playing God, deciding which banks are allowed to live and which should die. The market will make those decisions instead.

Tomorrow Is Too Late

The United States, and possibly the world, is facing the biggest financial crisis since the Great Depression. There is a strong sense that the government should intervene, but how? Thus far, the Treasury seems to have been following the advice of Wall Street, which consists of throwing public money at the problems. The cost, however, is escalating by the day. The time has come for Paulson to listen to economists and put forward a market-based plan that can actually work. Because the alternative—a legacy of debt in the hundreds of billions and a deep, prolonged recession—is frighteningly upon us.