The "washed out and blurry" condition is an emulation of how composite-input NTSC monitors worked. The "blurriness" is actually a kind of interpolation of dithered colors that take advantage of the monitor's display to "create" colors that the video card was not able to generate by itself, that is, the colors output by the video card would "bleed" together to generate a color that wasn't in the graphics card's palette.

The concept is sometimes also called "artifact coloring" and the Genesis/Mega Drive made heavy use of it. The following links can provide more information:
http://retro-sanctuary.com/comparisons%20-%20differing.html
http://nerdlypleasures.blogspot.com/2013/09/the-overlooked-artifact-color.html
http://nerdlypleasures.blogspot.com/2013/11/ibm-pc-color-composite-graphics.html

As far as I've been able to determine, MM1 did not make use of composite interpolation, but instead swapped between CGA's two color modes (Cyan/Magenta/White and Green/Red/Yellow) when necessary. The EGA implementation allowed all the necessary colors in one palette, which is why there is not much graphical difference between the two settings.

Starting with MM2, all DOS Might & Magic games supported VGA.