I would have terminated it. I'm not a privacy nut, but I am a respect nut... and if your level of respect for your engineers allows you to enforce such a ridiculous policy of "testing" in the interview process, well, you don't have much respect for the engineers... or their time, or their own privacy (on their own machine).
I wont work for a company who installs "screen watching" software on your machine. I wont work for a company who middle-man's the SSL cert. I wont work for a company who drug tests. (I smoke MJ, but a lot of companies state MJ doesnt fail, but I still refuse to take a drug test, its principle)
We aren't cattle. When you're treated as such in the interview process, you can strongly infer that you will be treated as such in your position.