The U.S. 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 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 bond fund managers, and was responsible for raising at least $500 million from investors to seed TCW's partnership with the Treasury. Gundlach was not available for comment on Wednesday.

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.

Los Angeles-based TCW, which oversaw $108 billion as of September 30, 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. It is one of the anchors of the Obama administration's plan to restore bank health and consumer lending.

The antennas are up, but in no way should there be any cause for panic about the PPIP, said Jesse Litvak, a managing director in mortgage trading at Jefferies & Co. in Stamford, Connecticut. There are seven other PPIP guys buying.

MOVE PRESSURES TCW

People familiar with the situation contend that the Treasury's suspension of TCW's PPIP fund was a routine response to the departure of Gundlach.

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withdraw money from TCW's flagship TCW Total Return Bond fund on Tuesday, though at about half the $1.2 billion rate withdrawn on Monday, TCW said.

It confirmed that on Tuesday it easily sold government agency-backed mortgage securities and $450 million of other mortgage bonds to meet client redemptions.

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 simultaneous takeover of Metropolitan Asset Management LLC, or MetWest, will bring on board 115 employees and $30 billion in assets.

TCW in a letter to clients said MetWest managers would immediately assume control of its high-grade bond accounts. MetWest has a world-class reputation, being nominated fixed-income manager of the year four times, including 2006, TCW said in the note.

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.

The $6.7 trillion market for U.S. mortgage-backed securities owes much of its rally since March to the PPIP and general risk-taking by investors who believe the bond prices fell too far, even given high levels of defaults and foreclosures. Prices have gained 20 percent to 30 percent from their lows, according to Guggenheim Capital Markets.

But the buying has now pushed prices too high for the funds to garner desired returns, and prices have softened. The PPIP managers will continue to have an impact, however, said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago.

The PPIP program as a whole is still up and running and the other 7 managers will continue to be actively involved in the markets, irregardless of what the Treasury decides what to do with this fund, he said.

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