Well I basically just do exactly what I show in the 1-hour video I posted to youtube 3-ish years ago. The basic process is this:

1. First apply any materials/textures to your model within blender making sure to note the name of the material (for example "adiponectin.tga").
   
2. Export your model to .smd format and generate a vtf/vmt using VTFedit.
   
3. Save these texture/material files using the exact same name as what was applied in blender (e.g. "adiponectin.vtf" and "adiponectin.vmt").
   
4. Create a folder structure of exactly how the model you want to replace looks like for the eventual mdl file (+associated files). Therefore if you want to replace the Bloke's Bucket Hat, you'll want to create a folder structure like \...\models\player\items\sniper\
   
5. The material folder structure doesn't matter as long as you specify where the vmt is in the QC file. The vtf location is specified by the vmt (it's easiest to just keep these two files in the same place).
   
6. Create your QC file. For the $modelname line, name the mdl exactly what the VPK version of the hat you want to replace is (e.g. "sniper_fishinghat.mdl").
   
7. With your .smd ready to go and your vtf/vmt in the correct folder, go ahead and compile the QC using GUIStudioMDL.
   
8. This will create the .mdl and associated files in the correct folder structure. To make this into a mod, simply create a folder that you want your mod to be named (example: Bubbles). Put your materials and models folder inside this folder, and then drag the Bubbles folder into the C:\Program Files (x86)\Steam\SteamApps\common\Team Fortress 2\bin\vpk.exe application. This will automatically make a VPK of the folder Bubbles. To install the mod, all you need to do is drag Bubbles.vpk into your C:\Program Files (x86)\Steam\SteamApps\common\Team Fortress 2\tf\custom folder.

If you need further help, all of this is described in the video:
https://www.youtube.com/watch?v=-X5QGx2TP_8

So I don't use the in-game compiler for mods, but theoretically it should work. When it compiles the model, it puts the mdl file (+associated files) in your C:\Program Files (x86)\Steam\steamapps\common\Team Fortress 2\tf\models\workshop\ folder and the vtf/vmt files in your C:\Program Files (x86)\Steam\steamapps\common\Team Fortress 2\tf\materials\models\workshop\ folder. When you are renaming the mod to replace an in-game item, you can move the mdl file out into the correct folder structure (without the /workshop/ folder), but keep the material folder structure how it is-- otherwise the mdl will be looking for the material in the \tf\materials\models\workshop\ folder which it can't find.

Hm.... that's really weird. Are you sure you didn't accidentally assign vertices offscreen (below) to the same bone? It also might be a center of reference issue. Try selecting the parts you want to rotate and setting the origin to geometry.

There isn't really a way to delete it with 1 button press, but you can easily select the whole thing by (in edit mode) hovering over one of the mask vertices, pressing "L", and then deleting the selected vertices.

The in-game hat models are located in the tf2_misc_dir.vpk file in the C:\Program Files (x86)\Steam\SteamApps\common\Team Fortress 2\tf folder. You'll need GCFscape to open the vpk, and when you do, navigate to the models/player/items/classname/ folder for mdls.

The only issue is that the in-game compiler not allow for this to work because the material path might be messed up if you try to change the folder locations. I'm fairly certain the compiler compiles both a workshop folder mdl and a regularly located mdl. Check to see if you can use the regular file location mdl.

Well I always just compile manually, but perhaps you could do it using the import tool. You'll need to get the name of the mdl file you want to replace. Let's say it's the bloke's bucket hat. When you compile your model, you'll want to rename your .mdl and associated files (.dx80, vtx, etc.) into exactly what the bucket hat's name is (which should be sniper_fishinghat.mdl). Put these files into a folder structure that mimics the VPK files (models/player/items/sniper). Do the same for the materials.

Then you'll want to turn your materials and models folders into one VPK file which you can put into your custom folder. Create a folder that you want your mod to be named (example: Bubbles). Put your materials and models folder inside this folder, and then drag the Bubbles folder into the C:\Program Files (x86)\Steam\SteamApps\common\Team Fortress 2\bin\vpk.exe application. This will automatically make a VPK of the folder Bubbles. To install the mod, all you need to do is drag Bubbles.vpk into your C:\Program Files (x86)\Steam\SteamApps\common\Team Fortress 2\tf\custom folder.

Ah, glad you figured it out.

Well I haven't heard anyone else having this issue, so it seems like something on your end. Are you using photoshop or gimp to make your textures? In the meantime, you can try reassigning all your materials from within blender.

Hm... I've never seen this error before. Did you accidentally assign more materials to the regular model than you did with the LOD? But even then it shouldn't give an error. I'm not 100% sure what's wrong.