Password similarity

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http://serverfault.com – I wanted to change my password on a unix machine. I did a normal "passwd" and typed in my old and my new password. Then the machine came back to me with the following message: BAD PASSWORD: is too similar to the old one That got me thinking... Does that mean, the machine has my password in clear text somewhere? Otherwise it should not be able to compare the old and the new password, right? Or is there a hash function, that enables that? (HowTos)