One work around that I have found is to comment out the first line in the sshd pam configuration.
#%PAM-1.0 #auth required pam_stack.so service=system-auth auth required pam_nologin.so account required pam_stack.so service=system-auth password required pam_stack.so service=system-auth session required pam_stack.so service=system-auth session required pam_limits.so session optional pam_console.so
Have you verified that users who enter the wrong password are not allowed to log in? It looks to me like they would be.
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