I feel better it wasn't just me being grumpy.
They are only 3 and 5 so having the older one miss out on a gift for taking the hat won't really work, she won't understand. I have noticed this seems to be a pattern, things given to them both to use are taken by the oldest and the younger one can only have them when the older girl has had her fun and moves on.
I will say this year the younger niece gets a handmade gift with her name embroidered on it, so it is marked as *hers*.
Don't sell you niece so short! At five there is definitely the ability to understand. There is no need to be cruel, but I do think that you can say to her "well, I guess that will have to count as your birthday present instead" and then replace the one for younger niece. Absent of developmental delays, the message will absolutely sink in.
These are little kids!!!
Try not to get too upset about it. At anybody. The parents are dealing with the issue as best they can. (I bet that making her wear the damaged hat *was* actually a punishment, at least for a while. She wanted it when it was perfect and lovely. I can't imagine that the parents would "make" her wear the hat if she was happy about it.)
I agree Millionaire Maria, that 5 is old enough to understand that the hat is her gift, if that makes you feel better. But she may not really mind anymore, even if she did when it was new--by now she's attached to it. So she may not see it as punishment, and actually it's not anymore YOUR place to punish her over this. That's her parents' prerogative, not yours. (But it sounds like they are pretty wimpy about it. Though, they *DID* put their foot down--and that's why the girl damaged the hat.)
And if you let this incident affect your feelings for her, I would say that's really, really short-sighted and unfair. She's five.