UPDATE 2-Fed's Stern says vital for GSEs to keep operating

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WASHINGTON, Aug 20 (Reuters) - Struggling U.S. mortgage finance giants Fannie Mae (FNM.N) and Freddie Mac (FRE.N) need to keep operating, and recent government steps to offer them support were "appropriate," Minneapolis Federal Reserve Bank President Gary Stern said on Wednesday.

The broader issue of whether a financial firm is too big to fail can be addressed when market conditions turn calmer, Stern said in an interview on Bloomberg TV.

He said the measures to back Fannie Mae and Freddie Mac were aimed at preventing their problems, which he said stem from the housing downturn, from further tainting the financial system.

"That's why government intervenes, whether its Fannie and Freddie or Bear Stearns or circumstances like that," he said. "If policy-makers were confident that the problems could be confined to the institution in question then you could certainly let that fail."

In March, the Fed backed a takeover by JPMorgan Chase & Co JP.N of ailing investment bank Bear Stearns amid widespread anxiety that it might fail and damage the nation's financial system.

Stern cited that as a justified intervention by the government to ward off escalating harm.

"It's really a concern about spillovers to other financial institutions, to the financial markets more generally and ultimately to the real economy," Stern said.

In response to questions about rate policy, Stern left little doubt that he considered the Fed's next move will be to raise rates but offered no hints on timing.

He said he expects inflation to ease in coming months.

"I'm cautiously optimistic that will occur, if it doesn't we may have to move," Stern said.

CONTRASTING OPINIONS

His view on the government-sponsored enterprises contrasted with that of Richmond Fed chief Jeffrey Lacker, who told Bloomberg TV on Tuesday he preferred to see them "credibly and demonstrably privatized."

Stern is a voter on the Federal Open Market Committee, the Fed's rate-setting group, this year. Lacker is not.

Shares of Fannie Mae and Freddie Mac tumbled to their lowest in nearly two decades on growing concerns about a government bailout that would wipe out their shareholders. For details see [ID:nN20394028]

While a plan to support them was needed, Stern does believe changes are need at Fannie Mae and Freddie Mac. He said the two companies should target financing to low- and middle-income borrowers, and this reorientation would shrink them and partly address the "too big to fail" issue.

Stern said he could not say how much exposure U.S. banks have to Fannie Mae and Freddie Mac's securities but "that's something that obviously we're going to be taking a look at."

Despite the credit storm that has lasted more than a year, most financial institutions have remained in reasonably good health, Stern said. (Reporting by Glenn Somerville and Richard Leong; Editing by Neil Stempleman)