This is a great thread Eli ... cheers!
How do search engines view a network of blogs that are subdomains of a main site (sort of targetedkeywords.nichekeywords.com) - would they penalise a few hundred WP blogs under one domain? Alternatively, how do links to subdomains affect the rest of the domain? Assuming they share an IP and are linked by a main index site.
Thanks!
Awesome question Hippy.

When it comes to subdomains there are some very gray areas and some concrete truths.
Gray Areas:
1) Subdomains perform better than subpages. This is yet to be proven. There are definite discrepancies on how the main page passes link value and domain authority to it's own subdomains. You can put a subpage up on a main site with tons of domain authority and it can automatically do well. However if you put up a page on a subdomain of an authoritative domain it doesn't necessarily do well. Look at subpages of Blogger.com and other blogging networks that have no link on the main page or direct subpages, in comparison to the blogs hosted on the subdomains.
2) Subdomains are treated like separate domains by the SE's. It's almost conclusive, but have you ever had a subdomain on an unsandboxable site get sandboxed? Have you ever had a site get banned but its subdomain stays in the index? I'm yet to see it.
Which brings me to the concrete areas.
Concrete facts
3) Subdomains cannot penalize the main domain. You can get a subdomain banned while at the same time your main page never even flinches in the rankings. This almost conflicts with point 2 except that its logical that the relationship between main domains and subdomains may be a one way street.
4) Main domains can affect subdomains but subdomains can't affect main domains. Everything i've ever seen says this is true. I could build a thousand links to my Blog Solution sites and all the subdomains would start performing better even the ones that got pushed out of the scrolling main page index. Yet the subdomains performed very poorly per capita.
Which brings me to answer your question:
Since subdomains are viewed as a separate entity from the actual domain than their links are viewed as inbound. Since no inbound link can hurt you(google bowling), than cross linking subdomains cannot cause a penalty to roll across to all of them. Any penalties you recieve will stop at the point of entry, with the exception of course, the main domain. If that gets penalized, all get penalized.
So the logical thing to do might be to link all the subdomains together in a serial fashion. Then only use the main domain to get crawlers to key entry points within certain subdomains and push a bit of authority. As long as you keep the main domain very clean even if you start getting banned like crazy you can still produce and produce until they catch your main page being in on the scheme. Which can only be accomplished by some form of human check. Wordpress MU? May be an option
