Over the weekend the British government announced that it was increasing its stake in UK bank Lloyds TSB (LYG) to 65% and possibly 77% in return for insuring over 367 billion dollars in toxic assets. The government will do that by converting some of its preferred shares in the bank into common. As part of the agreement, the bank will take a "first loss" of up to 25 billion pounds, with the U.K. government shouldering 90% of any subsequent loss.

Lloyds was one of the most conservative lenders in the UK which didn’t have as much exposure to toxic assets until it acquired troubled bank HBOS back in September 2008. The way events unfolded back in September and October when banks worldwide were acquired shows that virtually no due diligence was made given the tight deadlines for the deals to materialize.

Eighty percent of the toxic assets came from HBOS, which Lloyds agreed to buy in a government-brokered deal in September 2008. HBOS reported $14 billion of loan losses last year, up fivefold from 2007.

Because of the losses from HBOS acquisition, Lloyds has been forced to seek asset protection program. While the stability of the banking system might be ensured with this deal, shareholders of any banks are being diluted across the board. Even banks that didn’t take excessive risks during the boom years are suffering, as they are merging with competitors who held the majority of bad assets. This leads the acquirers to seek government assistance and cut dividends to maintain liquidity. This hits shareholders two folds – first their ownership is diluted and second their dividends are cut or eliminated.

A similar picture is being painted in the US as well, as the government recently converted a large portion of its preferred stock into common at Citigroup (C), raising its stake to 36% of the company by converting $25 billion in TARP emergency aid into commons shares.

Bank of America (BAC) might be largest casualty of the mortgage crisis. It completed its purchase of troubled mortgage company Country Wide Financial for $4.1 billion in July 2008. BAC also bought Merrill Lynch for a $50 billion in BAC stock. The bailout of Merrill Lynch was needed, as the company had an operating loss of $21.5 billion for the last quarter of 2008.