I don't have access to Windows Live Movie Maker at the moment, but one reason why you may be having difficulties is because, strictly speaking, CR2 (or any type of RAW) files are not images; they're just the data that is recorded by the camera when you press the shutter (so light levels plus details of the settings used and sometimes a little jpeg thumbnail image that shows what a typical image could look like when produced from this data). See this question for more discussion on this.
Looking at the online help for Windows Live Movie Maker, it seems that WLMM does not
allow the import of RAW files, and so I guess you'll have to convert the images to something such as jpeg/tiff/png (See this answer for a guide to image file formats) first and then import these into WILMM to make your time-lapse. If it were me I would want to ensure that the same processing was applied to every image in the sequence, so although some images may border on being under/over-exposed, transitions from light to dark and vice versa are captured properly.
In terms of output, H.264 is not a file type, but a compression standard that can be applied to a number of different video "container formats" such as .mp4 or .mkv. This video on Vimeo provides some overview on how to export videos using custom settings from WLMM.