I've always been against the loot systems in most games.  As for the current loot systems in games, I think it's downright broken. It's boring and monotonous, and its only use is to elongate the game's playthrough time for more than it needs to.  I mean, every sword is the same sword, but with different stats involved.  Even after all of that, the games usually have modifying items (e.g. gems in Diablo series) that augment a weapon that much more.  Which is unfortunate, as you never know when you'll get a better weapon that outweighs the one you already have, which, I may add, has the best gem you have equipped.  This makes any investment into a single weapon much less worthwhile than just waiting for a better drop at the end of the game and dumping your gems into that weapon.  Just give me one of each item that I will keep for the entire game that I can equip mods on whenever I see fit (e.g. Ratchet:Deadlocked).   

I actually thought Fable III would do this perfectly with the Hero Sword and Hero Hammer you got at the beginning of the game.  The initial premise of these weapons was they would increase in strength and overall usefulness as you went through the game (which DID happen).  However, I thought these weapons would be the only weapons you got through the entire game, and you would be able to modify them with the Augmentations (I'll call them 'Augs' for short) that have been prominent through the series.  For example, you could add a Fire Aug and Piecing Aug to your sword when faced against an undead enemy and be able to switch them out for two Lightning Augs when faced with a Balverine, or something.  Throughout the game, I assumed you could choose between permanently placing your currently placed Augs or adding more space on your weapon for more Augs.  Unfortunately, what the game actually offered was pretty bad: for each weapon you could unlock better modifiers after performing certain tasks (e.g. kill 200 Balverines with a gun to unlock a 10% Piecing bonus).  However, by the time you've come across this weapon, you've killed your fair share of Balverines with other weapons that did not ask for these actions to be performed to earn a modifier.   I haven't actually played Fable III, but I have seen enough of the game to know about the modifiers are handled.  That said, please alleviate on any details I may have forgotten along the way.
 
They way I would tackle the loot system has already been stated in the first paragraph to a smaller degree (i.e. have only one of each weapon that can be modified as the player see fit).  I'll expand on this idea by stating these modifiers (e.g. Fire damage increase) are the more significant of the two items in this discussion.  The mods make the weapon, not vice versa.  This, however, means you can't give out all the weapons out at once, else the player will feel less invested in the game.

  Randomize the mods the same way you would weapons in any other loot-based game made so far (e.g. Borderlands, Diablo series, Baulder's Gate series, Tourchlight, etc.).  These mods will have stats that are standard to most of these games (e.g. +10% Fire Damage/Resistance), but as these modifiers are what make the weapon what it truly is, the modifiers (shortened to 'mods' for convenience's sake) will also alter the overall function of the weapon through Modifier Combos, which will change the weapons overall appearance and function. 
 
  For example, if you put three different types of mods onto a sword, it will change into a claymore (which grants greater damage but is slower than the initial sword), whereas another combination of mods will grant the player with a chain-sword, similar to what Ivy from the SoulCalibur series wields.  Putting the same 'chain-sword' mod combo onto a pair of knives gets something similar to the Blades of Chaos from God of War.  Meanwhile, the weapons will upgrade on their own, granting more space for mods.  So, the player can increase the reach the chain-sword combo or add Poison Damage to it to increase it's effectiveness.

  As for other items, such as armor or shields, these modifiers will (for now) act as they have in other games (e.g. increase Dark Defense by +20%, provide Drain Health).  However, the player can wear whatever they want (similar to Fable II) and still have these mods equipped to modify overall defensive performance.  I'll have to think more about how they will effectively add to the effectiveness of armor and other forms of defensive protection.
 
This system may all seem a little confusing, so let me know if there's anything you want clarification on.