I've just tested the following page in IE8 and it's working:
http://c5extras.com/add-ons/youtube-background/...

I did find the video took a bit longer to load than other browsers. How big is the video (in MB)?

What version of IE are you using? I find that the video doesn't tend to be as smooth in IE than other browsers, but that would be a memory management issue to do with the browser, rather than this particular add-on.

Does the add-on load the ENTIRE video before it plays it or does it just stream it like you're watching it on Youtube?

It should stream it as it's using the YouTube API. But depending on the the internet connection and length/quality of the video, buffering time may fluctuate a bit. Also the browser and computer CPU/RAM/etc would affect how much processing can be done.

question - what if youtube bogs or drops while someone is on your site?

Fair enough question. If there are issues with YouTube, the video simply does not display. No errors are shown.

But in all reality, with Google's infrastructure behind YouTube, your own server is 1000x more likely to go down then YouTube's (no offence intended) :-)