We have recently discovered Japanese children with a novel Fanconi anemia-like inherited bone marrow failure syndrome. This disorder is likely caused by the loss of a catabolic system directed toward endogenous formaldehyde, due to biallelic variants in ADH5 combined with a heterozygous ALDH2*2 dominant-negative allele (rs671), which is associated with alcohol-induced Asian flushing. PHA-stimulated lymphocytes from these patients displayed highly increased numbers of spontaneous sister chromatid exchanges (SCEs), reflecting homologous recombination repair of formaldehyde damage. Here we report that, by contrast, patient-derived fibroblasts showed normal levels of SCEs, suggesting that different cell types or conditions generate varying amounts of formaldehyde. To obtain insights about endogenous formaldehyde production and how defects in ADH5/ALDH2 affect human hematopoiesis, we constructed disease model cell lines, including iPS cells (iPSC). We found that ADH5 is the primary defense against formaldehyde, and ALDH2 provides a backup. DNA repair capacity in the ADH5/ALDH2-deficient cell lines can be overwhelmed by exogenous low-dose formaldehyde as indicated by higher levels of DNA damage than FANCD2-deficient cells. Although ADH5/ALDH2-deficient cell lines were healthy and showed stable growth, disease model iPSCs displayed drastically defective cell expansion when stimulated into hematopoietic differentiation in vitro, displaying increased levels of DNA damage. The expansion defect was partially reversed by treatment with a new small molecule termed C1, which is an agonist of ALDH2, thus identifying a potential therapeutic strategy for the patients. We propose that hematopoiesis or lymphocyte blastogenesis may entail formaldehyde generation that necessitates elimination by ADH5/ALDH2 enzymes.