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Has anybody tried a mod along these lines? See any balance / other issues?
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As fyron said. Godzilla size balance issues.
Leaky armor is the way to go...
With a proper implementation, the leaky armor dosen't degrade very much per hit, and blocks most hits. Occasional damage to internals with the rate dependent on the amount of armor.
Also, in space, you don't sink.

With the leaky armor, ships get disabled long before you vaporize the last slabs of armor on the burned out skeleton, leaving you with lots of twisted wrecks floating in space after a big battle
