Why unencrypted passwords

A server with access to a cleartext secret can send a "challenge" and demand the client provide a hash of the challenge + secret to login, preventing the transmission of the password over an unencrypted connection. This is used, for example, by the APOP command of pop3. (And if that sounds rudimentary, Outlook doesn't even bother to do this - it just sends it as plaintext.)

But to do that, the server needs access to an unencrypted password. Even if you use encryption on the password file (properly salted, to prevent the use of rainbow tables) then chances are anyone who can get at the password file can get at the master key and decrypt them.