The Treasury Department said on Wednesday it froze a $1 billion public-private investment fund set up by TCW Group Inc to buy toxic financial assets, saying the departure of star manager Jeffrey Gundlach triggered a key person event in the partnership.

The Treasury's move is raising eyebrows in the mortgage-backed securities (MBS) market that owes at least part of its recovery this year to expectations that some $40 billion in demand from the nine approved public-private funds would ensure a bottom in prices was likely after a two-year drubbing.

At the heart of the matter is the depth of Gundlach's experience in the MBS market. On Friday TCW said Gundlach was fired after he threatened to take certain actions that could have jeopardized the firm's ability to manage clients' fixed income assets. Gundlach is among the best-known fund managers, and was responsible for raising at least $500 million from investors to seed TCW's partnership with the Treasury.

Treasury has notified TCW that a Key Person Event has occurred under the Limited Partnership Agreement, Treasury spokeswoman Meg Reilly said.

Upon the occurrence of a Key Person Event, the PPIF cannot make investments or dispositions, she said in an email. Treasury is currently evaluating its options as an equity and debt investor in the PPIF.

TCW, one of the largest money managers in the world, was chosen from an estimated 100 applicants for the PPIP, in which the government matches capital and offers debt to the funds to buy distressed assets weighing on bank balance sheets.

Clients continued to withdraw money from TCW's flagship TCW Total Return Bond fund on Tuesday, though at about half the $1.2 billion rate withdrawn on Monday, TCW said.

Including Gundlach, some 15 employees were fired or resigned from TCW, or nearly one fourth of its 65-person fixed income investment team. However, TCW's takeover of MetWest will bring on board 115 employees and $30 billion in assets.

TCW in a letter to clients said managers of Metropolitan Asset Management LLC, or MetWest, would immediately assume portfolio management. MetWest has a world-class reputation, being nominated fixed-income manager of the year four times, including 2006.

Among the range of possible outcomes of the review, Treasury may agree to make MetWest co-founder Tad Rivelle the new key man and allow the TCW fund to proceed.

We are in regular communication with Treasury and working to ensure we meet their contractual due diligence requirements, TCW said in a statement. We feel we've brought in a team that can match skill for skill and ensure continuity and stability in managing clients' assets.

TCW declined to comment on client activity in its funds or the Treasury review.

(Reporting by Joe Giannone and Al Yoon in New York, and Tim Ahmann in Washington)