I've never heard that story from either Bil or Dave.
From On The Edge:
To fix the problem, Herd required the C128 to start at memory address zero, but the 8502 started elsewhere. "One night, everybody left and it was broken," says Herd. "During the night, I said, 'I have no way to fix this, unless we startup by not starting at that address.' I said, 'Hey, Von. The Z80 chip starts from zero, doesn't it?' He said, 'Yup.' I said, 'Cool. I need somebody wire wrapping tonight.'"
The hour was too late to purchase a Z80 chip, so Herd looked elsewhere. "Everybody had doorstops that were actually Sinclairs," he recalls. "I went and tore open my doorstop because we didn't own a Z80 chip in the place."
I don't believe they re-used the Z80's in production models though. After hearing about how the C64 was put into production for Christmas however, nothing would surprise me

Putting in an 8088 would likely have not helped much as making the computer MSDOS compatible to any real degree would have been impossible. An NEC V20 would have been better as it could run CPM in it's 8080 mode, but you can also run 8086 software. It lacks the extra Z80 instructions but most CPM software is compatible with 8080 anyway (Z80 is an 8080 clone with added instructions). It might not add much, but you also wouldn't really lose anything.
The C128 was like the A3000. Both were based on custom chips from a previous design, but with extra glue around them because there was no time/money/inclination to improve them. If the C128 had an 80 column VIC that could work when the CPU was running at 2mhz then it would have been a worthwhile upgrade & much closer to the C65 but still C64 compatible.
The C65 was designed during the time when AAA was in development hell, I can understand why in that environment the C65 project would have made some sort of sense and it probably would have sold if it was cheap enough. Another couple of engineers also went off and pushed through the Pandora project, which turned into AGA.