Lenders are making a much bigger return on equity on two- and three-year fixed rate mortgages than on heavily discounted standard variable rates, a report issued yesterday shows.According to the latest JP Morgan/Fujitsu Australian Mortgage Industry Report, the current net interest margin on a mortgage fixed at 6.59 per cent for three years is 99 basis points, and the return on equity is 48 per cent.The net interest margin on a standard variable rate mortgage, priced at 7.8 per cent but discounted by 90 basis points to 6.9 per cent, is 75 basis points, and the ROE is 37 per cent.If the loan is discounted by 115 basis points (the biggest discount currently on offer) the net interest margin on a standard variable rate mortgage falls to 50 basis points, and the ROE falls to 24 per cent.These unusual dynamics come about because the two- and three-year swap rates that lenders use to hedge their fixed-rate exposures have fallen below short-term rates this year, allowing lenders to cut their fixed rates hard and still make a high return on the loan.According to the report, with a 90-day bank bill rate of 4.85 per cent and a spread of 1.3 per cent, the cost of funding a standard variable-rate mortgage is 6.15 per cent. But, with the cost of the three-year swap rate at 4.30 per cent with a spread of 1.3 per cent, the cost of funding a three-year fixed rate mortgage is 5.6 per cent.Given all this, it is no surprise that lenders have been promoting fixed rates that are lower than variable rates. And borrowers are responding.Mortgage aggregator AFG reported this week that 16.6 per cent of the loans written by its brokers in September were fixed-rate mortgages. The proportion of fixed-rate loans was up from 9.4 per cent in August and 7.9 per cent in July.JP Morgan's banking analyst, Scott Manning, said lenders had discounted variable rate loans about as much they were prepared to do. They expect a minimum ROE of 20 to 25 per cent on a mortgage and the heavily discounted variable rate loans were at that level now.Lenders would continue to promote the more profitable fixed-rate product.Manning said lenders would also be reluctant to push discounts any further because of the uncertainty about their funding. Manning said: "Loan discounts have been funded through an easing in deposit rates. If the European debt crisis affects access to wholesale funding deposit rates could be squeezed up again."Manning dismissed suggestions that the heavy discounting had weakened loan underwriting standards. "These discounts are offered selectively. The same serviceability buffers are in place, loan-to-valuation ratios are low and arrears' rates a very good relative to global peers."