Imagine you are a program director, or an assistant program director. Your job is to look at 500 applications for 30 positions. You aren't going to scrutinize every application, after all, you'll probably interview 300 people.
What looks better? A transcript full of H's or a transcript full of Ps? Thoughts going through the director's head:
1. "Why did this guy get all Ps? Whats wrong with him?"
2. "PASS!? Wait, is this school all pass fail? Acutally, having to check isnt worth my time, look at all these Hs on the next guy's app!"
3. "AHAHAHAHAHAHAHAAHAHAH next!"
P = MD, that is true. P != Residency. Most basic science programs are pass fail now. The way you separate yourself as "excellent student, learned alot, and plays well with others" is with third year grades. Is it true? Does an honors mean that? Probably not (look at all the disgruntled grades threads in this forum). But if you DONT have honors (or high pass), you almost certainly DO NOT have what it takes to study hard and play well with others. Thats the assumption, anyway. Why would someone take the risk on someone who is in the bottom of his class with a bunch of Passes?
Bottom line, third year grades separate excellent applicants from the rest. Get all those Hs on your transcript and go to the program of your choice (presuming you also have the Step score, since, well, no one will look at your application if you dont have a step score cutoff).