For starters the Xenon uarch (powerPC) was only 3 cores. Jaguar (x86) is 8, so a direct translate will already eliminate 5 of the cores. They will always be idle because the game was never designed to scale to 8 cores.
If Microsoft pulls this off, I would be very impressed. If they do it via the cloud, they could throw significantly more processing power behind it.
Actually, Xenon is an SMT chip, so you're only partially correct. It has three cores, but six threads. So a lot of games actually ARE capable of scaling easily to at least 6 cores, leaving two free to assist in emulating other components. Also the modern-day out-of-order Jaguar cores are pretty darn competent compared to the older in-order PPC cores used in Xenon. More so than you give them credit for. They also may be able to lean on the AVX units to handle VMX code. With that being said, I still don't think they have enough raw power given the broad architectural differences and inherent difficult in emulating very different systems. Maybe with a really advanced dynarec engine and game-specific profiles?
But their best bet is cloud-based, and I think that's the direction they'll go. However, given how powerful their cloud is, I don't really see this as a bad thing. They've got tons of server power all over the place, so if you've got a halfway decent connection it should work pretty well for most games. Anyway, something is better than nothing. I just hope they'll eventually support XBLA games purchased on 360.
Also, I see they fixed formatting! Hurray, no more need to manually edit everything in the forums!