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You guessed correct! Most newer AV receivers will upconvert and output everything on the Component Video (Green, Blue,Red) or even HDMI to your TV. So if you upgrade your receiver in the future and your best output on the Source equipment is s-video you can use those in the future. The only...

You are Creating a video "loop". You need to use the receivers Multi-Rec out switch and switch that to the source that you want the line in on the VCR2 to see. If you haven't changed that and have the Reciever set to VCR2 the Receiver is sending VCR2 out to line in on VCR2 and Line Out of VCR2...