ssh localhost not working, authenticity of host can't be established - macos

Question

After checking permissions on $HOME and .ssh and running recommended commands am still having trouble getting ssh localhost to work without password. Below is edited history of my commands and output from ssh -vvv localhost. It is failing to load id_rsa and I can not figure out why. Running on Max OSX yosemite 10.10.5
java version "1.8.0_66"
Java(TM) SE Runtime Environment (build 1.8.0_66-b17)
Java HotSpot(TM) 64-Bit Server VM (build 25.66-b17, mixed mode)
I have remote login enabled from preferences.
zak-keirns-imac:~ zak$ ls -l .ssh
total 40
-rw------- 1 zak staff 2252 Dec 13 12:28 authorized_keys
-rw------- 1 zak staff 668 Dec 13 12:28 id_dsa
-rw-r--r-- 1 zak staff 615 Dec 13 12:28 id_dsa.pub
-rw------- 1 zak staff 1679 Dec 13 11:28 id_rsa
-rw-r--r-- 1 zak staff 407 Dec 13 11:28 id_rsa.pub
zak-keirns-imac:~ zak$ ssh-keygen -t dsa -P '' -f ~/.ssh/id_dsa
Generating public/private dsa key pair.
/Users/zak/.ssh/id_dsa already exists.
Overwrite (y/n)? y
Your identification has been saved in /Users/zak/.ssh/id_dsa.
Your public key has been saved in /Users/zak/.ssh/id_dsa.pub.
zak-keirns-imac:~ zak$ cat ~/.ssh/id_dsa.pub >> ~/.ssh/authorized_keys
zak-keirns-imac:~ zak$ ssh -vvv localhost
OpenSSH_6.2p2, OSSLShim 0.9.8r 8 Dec 2011
debug1: Reading configuration data /etc/ssh_config
debug1: /etc/ssh_config line 20: Applying options for *
debug2: ssh_connect: needpriv 0
debug1: Connecting to localhost [::1] port 22.
debug1: Connection established.
debug3: Incorrect RSA1 identifier
debug3: Could not load "/Users/zak/.ssh/id_rsa" as a RSA1 public key
debug1: identity file /Users/zak/.ssh/id_rsa type 1
debug1: identity file /Users/zak/.ssh/id_rsa-cert type -1
debug3: Incorrect RSA1 identifier
debug3: Could not load "/Users/zak/.ssh/id_dsa" as a RSA1 public key
debug1: identity file /Users/zak/.ssh/id_dsa type 2
debug1: identity file /Users/zak/.ssh/id_dsa-cert type -1
more output:
debug1: Enabling compatibility mode for protocol 2.0
debug1: Local version string SSH-2.0-OpenSSH_6.2
debug1: Remote protocol version 2.0, remote software version OpenSSH_6.2
debug1: match: OpenSSH_6.2 pat OpenSSH*
debug2: fd 5 setting O_NONBLOCK
debug1: SSH2_MSG_KEXINIT sent
debug1: SSH2_MSG_KEXINIT received
debug2: kex_parse_kexinit: diffie-hellman-group-exchange-sha256,diffie-hellman-group-exchange-sha1,diffie-hellman-group14-sha1,diffie-hellman-group1-sha1
....
debug2: kex_parse_kexinit: none,zlib#openssh.com
debug2: kex_parse_kexinit: none,zlib#openssh.com
debug2: kex_parse_kexinit:
debug2: kex_parse_kexinit:
debug2: kex_parse_kexinit: first_kex_follows 0
debug2: kex_parse_kexinit: reserved 0
debug2: mac_setup: found hmac-md5-etm#openssh.com
debug1: kex: server->client aes128-ctr hmac-md5-etm#openssh.com none
debug2: mac_setup: found hmac-md5-etm#openssh.com
debug1: kex: client->server aes128-ctr hmac-md5-etm#openssh.com none
debug1: SSH2_MSG_KEX_DH_GEX_REQUEST(1024<1024<8192) sent
debug1: expecting SSH2_MSG_KEX_DH_GEX_GROUP
debug2: dh_gen_key: priv key bits set: 135/256
debug2: bits set: 508/1024
debug1: SSH2_MSG_KEX_DH_GEX_INIT sent
debug1: expecting SSH2_MSG_KEX_DH_GEX_REPLY
debug1: Server host key: RSA 02:f8:78:65:22:75:23:44:c4:82:2a:8f:73:4b:f5:6a
The authenticity of host 'localhost (::1)' can't be established.
RSA key fingerprint is 02:f8:78:65:22:75:23:44:c4:82:2a:8f:73:4b:f5:6a.
Are you sure you want to continue connecting (yes/no)? no
Host key verification failed.

Answer 1

debug1: identity file /Users/zak/.ssh/id_rsa type 1
This line tells you that the identity was loaded successfully.
debug3: Could not load "/Users/zak/.ssh/id_rsa" as a RSA1 public key
This is just low-level notice, that the old key type was not recognized. This part is there for some historic reasons and is a bit confusing, but it is NOT an error, just debug3-level note.
The authenticity of the host is something totally different. The keys you generated are used for authentication, but the authenticity is assured by host keys.
If you wan to make sure that you are connecting to right host, copy the public hostkey from server to your ~/.ssh/known_hosts using different secure channel and you will not see this message again.

Answer 2

ssh does not give special status to localhost; it is treated as just another host. Before ssh will connect to a host, it wants to know that it is connecting to the correct host. There is no way for ssh to be able to answer this a priori. You need to verify the host key and confirm it for ssh. At that time, ssh will save it in your known_hosts file. As Jakuje pointed out, you can also copy the key to this file manually.
For localhost, verifying the key is a little easier because it can be found locally in /etc/ssh/ssh_host_rsa_key.pub (on Red Hat-like systems; location will vary on other OS). Once you identify the host key file, you can get its fingerprint with:
ssh-keygen -l -f /path/to/host_key.pub
When you are asked to verify the host key, you can say yes if the fingerprint presented matches the one you computed.
When connecting to a host for the first time, you should determine the host's key fingerprint in advance; this is more challenging with remote hosts. The reality is that most people do not do this, but it is the correct thing to do.