My buddy is rebuilding my 18 spline transmission and found this inside the 1st gear cluster gear. Inside the bore it's starting to flakey/scale. What would cause this?

cluster gear.jpg
[img]http://www.imgur.com/hxlGUJt.gif[/img]
4-speed
3:54 Dana
13.01 @107.93 with street tires (not hooking up)