As another reply mentioned, to prevent DNS rebinding attacks. The general expectation is you will whitelist domains from which you expect RFC1918 responses.
In fact, some people block domains by routing them to 127.0.0.1 in their host files. I've used private ranges too, in places where loopback might possibly do something funky.
> Serve malicious updates from a locally controlled machine. Lord knows about auth.
Wouldn't they have to break into my local machine first, plant an update service, and an update? That doesn't seem to scale well at all, and wouldn't it be easier to just break into the machine they want to 'update'?
The erroneous DNS change wouldn't help that sort of exploit. It just redirects attempts to contact microsoft.com to a local address, probably a router.