Thank you for your prompt responses and being so helpful. I found another 
solution though I'm not sure why it works:
1) apt-get purge libcap2-bin
2) apt-get install libcap2-bin
3) Comment out the offending line in /etc/pam.d/common-session
Pity I didn't come up with that idea before.

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https://bugs.launchpad.net/bugs/744877

Title:
  'passwd' doesn't change user's password after installing libcap2

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