Rails sets $KCODE to "UTF8" by default since 1.2.
Thus, unless you set $KCODE to something else the Ruby interpreter expects source code in UTF-8. That is, your editor is using latin1 to write the file just fine, but Ruby still expects UTF-8 because you configure that option in the interpreter via $KCODE. Just assign
$KCODE = 'NONE'
Additionally, it would be healthy to explicitely configure the database driver as well in database.yml, in MySQL that would be for example