Very little of this is true. Windows ME runs all the 16-bit code you can throw at it and supports all ISA devices identically to 95 and 98. Windows 9x were just as 32-bit as ME and supported PCI just fine.
The only thing they removed support for was booting into real-mode DOS, and started ignoring your autoexec.bat and config.sys files for the most part. You can hack that back into the OS pretty trivially, it's purely cosmetic and has nothing to do with the underlying architecture. They probably did this in an attempt to hide its creaky MS-DOS roots, and to get customers more used to not being able to run pure DOS before the inevitable shift to NT.
Windows ME was a product even Microsoft seemingly didn't really want to make -- nothing but a last-minute stopgap measure until they got XP ready. No one liked it at the time as it was basically Windows 98 but worse. There are some good parts, though -- improved USB support, for instance -- and therefore there are now projects that "backport" features from Windows ME to Windows 98 so you can get the best of both worlds.
No it doesn't. Windows ME didn't just remove support for booting into real-mode. It removed support for VxD drivers.
In Windows 3 Microsoft introduced virtual device drivers (VxD) that allowed applications to share hardware, these VxD drivers actually just mediated access to a real-mode 16 bit driver. This allowed hardware manufacturers to write one driver to support MS-DOS and Windows.
In Windows 95 they allowed you to implement VxD with true protected-mode drivers that lacked backward compatibility but with much higher performance. This was supported right up through Windows 98SE. Technically though a manufacture only need to ship a real-mode VxD driver to support MS-DOS, Windows 3, and Windows 9x if they didn't need high performance benefits of a protected-mode driver.
The WDM driver model was introduced with Windows 98 and it simplified driver development but was only compatible with operating systems >= Windows 98. So apart from sound cards that benefited from the WDM driver model introduced in Windows 98, a vast array of hardware only supported real-mode VxD drivers.
There was actually an issue that plagued Windows 9x where if the OS detected an instability in a protected-mode VxD driver it would put a flag in the registry to permanently stop the OS from attempting to load protected-mode drivers and your system be stuck running real-mode drivers resulting in significant performance issues with IDE devices.
IIRCC Microsoft announced the drop of support for VxD in Windows ME like 2 months before it went Gold. Because most modern hardware was PCI based and using WDM, this resulted in a lot of ISA/16-bit hardware just never getting ported to Windows ME and a lot of hastily written and inherently unstable WDM drivers for a few products that did.
This impacted a lot of folks, I remember Creative Labs having issues with WDM drivers on their sound cards for years.
No, it really didn't. Windows ME supports VxD drivers just fine.