#1 is correct, but there is a lot of stress on HAP, and the "-pee" part is very short, very light, very soft. It is not a long, clear, singing vowel.
ahdictionary.org, as I expected, shows only one pronunciation, and the e on the end is written ē, indicating the "long e" or -ee sound.
And it is definitely a P and not a B. When you say "happy" there is a definite puff of air on the "p."