To be fair to MS, I don't think they are going to put this into, say "wordpad" or whatever software you think you normally use. It's oriented toward the MSN-like features, such as messanger and maybe in the future toward software that is free, but with a small, sponsored, twist.
Obviously the privacy will be an issue, and you just know that you absolutely can't trust these companies, because as the track record shows - sooner or later there will be a slip up, and ID data will leak.
Suppose thought, that the system is designed to look for some keywords and if such are found, display the relevant ad, without actually retaining any data on remote servers; It might not be all that bad, if you get something free in return.
For now the Google's advertising model seems to be holding up better than the rest, but Google is only a virtual god. In the truRealm (tm) of our everyday lives, advertisment companies DO want to know who you are, how much money you have and what are you interested in: data, which is a total violation of privacy, at least in my opinon. And the model these companies will use is clear - sexy girls (if that's your thing) will at random spawn here and there to sell you stuff you can barely afford but desperately want. Microsoft is just thinking ahead on this one.