They know it's not illegal, that's why they aren't sending the police round to your door. If you modify your hardware then they have the right to ban you from Live. That's the agreement you make with Microsoft when you buy the console so they're entitled to do it. Why would they do it? It's pretty obvious - to try and deter people from chipping. Maybe your friend will get pissed off, but maybe some of his friends or the people that read this thread will be pushed away from chipping. He should suck it up - he cheated, he got caught, that's how it goes.
He'll just get rid of his X-box now and get a PS3