Right, I forgot that ~ has to be secure as well.

Yes this is documented and desired as the default behavior. From man
sshd_config :


     StrictModes
             Specifies whether sshd should check file modes and ownership of 
the user’s files and home directory before accepting login.  This is normally
             desirable because novices sometimes accidentally leave their 
directory or files world-writable.  The default is “yes”.


You can turn this off in /etc/ssh/sshd_config by changing

StrictModes yes

to

StrictModes no

Though it is not recommended.

I will go ahead and convert this to a question.

** Changed in: openssh (Ubuntu)
       Status: Incomplete => Invalid

** Converted to question:
   https://answers.launchpad.net/ubuntu/+source/openssh/+question/132640

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ssh autologin fails to work
https://bugs.launchpad.net/bugs/669338
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