You can use Calculate Value (from model only tools) to get this value. If you put this python expression in Expression argument, %Name%[:2], it should give the first two letters of the Name in-line variable in a new variable, output_value by default. Then you can introduce this into your query builder as in-line variable, for example, "st_abbrv" = '%...
Is this file being created somewhere else, or is it not being created at all?
The literal answer to this question is, "It is being created, but it is not a file."
The answer you probably want, though, is more like...
The file path that you assigned to output_layer is not being used as a file path, but merely as a string identifier for your new layer. The ...
The following is how I would solve such a problem. The method is not tested.
# define workspace
workspace = r"C:\GIS\Data.gdb"
arcpy.env.workspace = workspace
# list all feature classes
fullList = arcpy.ListFeatureClasses()
# set up empty list
resultList = 
# iterate through files in list and fill new list
for item in fullList: