Student Loan Co-Sign

My wife co-signed a student loan for her brother several years ago. He has not finished school and is not paying his loans, especially not the one that my wife co-signed on. The loan was through Citizens Bank and is now in default and in collections with Mercantile. One of their people calls my wife very frequently and is very rude when he calls. We understand the effects of co-signing and realize that we are every bit as liable as her brother. The loan is for about $8,000. We called Citizens to set up a payment plan and they said we could pay whatever we wanted, so we paid $100. Mercantile has since called us telling us we cant pay Citizens, we have to pay them and essentially gave us three options:

1.) Take a settlement of $4,600 and the loan will be gone. Of course, to do this we are going to have to borrow money. I know that this looks bad on a credit history, I just dont know how bad.

2.) Pay $1,500 down now, and then pay $100 a month electronically linked to a checking account until it is paid off. The downfall here is that they say the derrogatory credit will not be removed until the debt is paid in full.

3.) Do nothing and they say they will escalate things, possibly even hiring an attorney.

We obviously do not want number 3, so which one of the first 2 is a better option. How long does it take a settlement to come off your record? If we choose the payment plan we want to have the withdrawls linked to her brothers checking account. What happens if he somehow doesnt have the money or something like that?

Any help would be greatly appreciated. If you guys know of any other possible solutions, I would appreciate it.