How I would implement repairs and degradation:
1. Hammers only usable at anvil + forge. To repair with hammers you'd need the proper materials (seeing how mining is in the game and connected to smithing, the materials are already in). This would, for example, make Daedric less of be-all end-all ultimate mega equipment and more of extravagant items for the very-very-very best and richest of people (like Divayth Fyr). Seeing how Daedric is made of enchanted ebony (as far as I can remember), it would also give enchanting and enchanter NPC's a bigger role (skill interdependence).
2. If you don't have hammers or the material, you could turn it in to a smith/armourer and pay for him to do it. This would cost money and time rather than materials. The more high-level the armour/weapon, the costlier and slower the repair. This would make low level equipment more useful further in to the game and at higher levels, and would stop your character from having hundreds of thousands of gold near the end, due to repair costs.
3. High-level equipment should have high durability, meaning that it wouldn't need to be repaired as often. Low level equipment should break more easily, but should be repaired cheaply and quickly; maybe even without a hammer, forge and anvil. Leather armour, for example, could possibly be repaired on-the-go with scraps of leather and thread, making it hugely useful even for high-level characters instead of being trash at level 10.
In my opinion, this implementation would make armour extremely diverse and even out the playing field between items. Instead of making equipment upgrades into a linear progression, it would make sense to choose different kinds of armour depending on factors like skill in smithing, the need to return to town for repairs and your character's economy.
It's a shame that Beth has had the mentality of "let's just remove it instead of fixing it" lately.
I agree, that would have been a fantastic system that would have added a lot to the game. Easy to implement as well.
I would add to point 1 that the maximum percentage you can repair depends on your smithing skill, similar to Fallout 3. Maybe make it easier to repair low level equipment to 100% than high level equipment, so someone with a smithing skill of 25 could repair an iron armor to 100%, but not a Daedric armor.
And I would add to point 3 that equipment 'health' should be a factor that would set equipment apart from each other. Glass weapons for example should cause high damage, but break easily. Ebony weapons should cause slightly less damage than glass, but they should degrade very slowly only. This would be much more interesting than Daedric is better than ebony is better than glass is better than...
Now add enchanting capability as a stat to equipment like it was in Morrowind and you'd have a really interesting system where you really have to choose carefully which equipment is suited best for you. High damage? Enchanting capabilities? Reliability? Unfortunately it's not even worth asking whether they brought back the Morrowind system. Otherwise they couldn't implement their 'look, this is your biggest, baddest sword, now don't waste your time in menu mode and go kill people' system.
It's a shame that all these possibilities were wasted and instead they opted for a cheap action RPG approach.