Well folks, after months of time, energy, and heartache, I FINALLY figured out my problem.
On the cylinder head, there are two dime-size holes towards the center on either side of the cam chain channel. It seems that these holes are supposed to have a press-fit button cap over them, so that they are sealed. Mine were open. I didn't really notice this the first time I had it apart. but today I did...and my telescoping magnet pick-up device found the caps hanging out in the bottom of the engine, below the crankshaft sprocket.
It seems obvious to me that this is my problem, as there is sure to be a free flow of oil through these holes into the water jacket below, and vice-versa. Who woulda thunk? Well, I now have the caps snugly pressed back in their holes, and hopefully tomorrow I will have a clean-running Bandit 400 under my belt.
My question is, why do these holes even exist in the first place? My only guess is that for other applications (GSXR400 perhaps?) they may allow for a link between the two sides of the engine for better coolant distribution... Any ideas?