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Your version of PSE is way older than supporting these types of raw files, and I even wonder if NEFs were around for PSE v1(??)
In any case, I believe PSE is finding some way of opening the embedded JPEG, which may or may not be smaller and definitely 8bit.
If I were you, I'd look into PSE v6 or Lightroom ...
If you are REALLY using Photoshop Elements version 1.0.1 I don't understand how you are opening NEF files at all. Support for raw images was not added to Photoshop Elements until version 3, and the current version of Elements for the PC is version 6.
Raw images need to be processed using a raw converter. The newer versions of Photoshop Elements include a plug-in, Camera Raw.8bi. This plug-in allows you to open the raw image and make some adjustments to it. Among those adjustments is the capability of specifying the bit depth of your images.
As I think more about it, and again if you are REALLY using version 1.0.1, Elements is most likely opening and displaying the embedded JPEG image which is part of every raw file. You need to do some reading and do some updating of your software if you really want to work with the raw images.
It's almost certain that you are using Nikon's raw converter plugin. It is
normally installed along with the other Nikon software. The unsupported
color depth warning is due to earlier versions of elements not supporting
16 bit images. When you finally get the image, it is a 8 bit per channel
version of the 16 bit image.
There is nothing wrong with working with the 8 bit image. You will not see
a significant quality loss, though it is true that many people swear by the
higher bit depth. You are using Nikon's converter, not Camera Raw.
If you want to use Camera Raw, upgrade to the current version of Elements.
Be aware that the elements version of Camera Raw has some features removed
that are available in the Photoshop version.
Thank You so much for the information. I will try and look into an upgrade or just getting a newer version of PSE. Thank you so much.