I think the line above (in the radius -X output) that reads, "[mschap] No MS-CHAP-Challenge in the request" may be causing the issue (i.e. - not testing it properly for MS-Chap - sending a cleartext username and password instead of what the MS-Chap module expects?).
You hardcoded Auth-Type := MS-CHAP didn't you? You know how the wiki and the users file and numerous posts on the mailing list say that setting Auth-Type manually is wrong? You might want to follow their advice...
Any assistance would be greatly appreciated. I have and am continuing to scour the internet for anything that might fix this issue.
http://wiki.freeradius.org/NTLM-Auth-with-PAP-HOWTO -Arran Arran Cudbard-Bell a.cudbardb@freeradius.org RADIUS - Waging war on ignorance and apathy one Access-Challenge at a time.