Our builder thinks it's because of the type and grain of wood

Builder is correct.

Do you not see how it's the grain that's raised and not the stain?

Thanks, PPF. The stain company said that the second coat would cause the stain to peel at the weakest points in the wood, so I was wondering if that's what was causing the grain to raise up.

We have the exact same peeling on some of the cedar boards of our swing set.  Sanding and restaining is a relatively easy fix,  but unfortunately it's something that will likely have to be done periodically.  I'm not sure what you can do to protect the galvanized nails.  Maybe sand it by hand near those areas?

I said the same thing last year, that is the wood, its the grain of the wood and the way it was milled (not that anything was done wrong). Wood is naturally occurring and this peel happens often, especially in a soft wood like cedar.

There is a moisture problem in the wood. If you look above the boards that are effected you can see gaps. Rain water is getting behind the wall. Swelling the wood grains. Possibly the reason the manufacturer says 1 coat so that it can breathe, let the moisture in the wood escape.

It could also be effected by how the wall was built. They have to have a way that allows for moisture transfer. I can't see behind the boards, a rainwall is not uncommon for this construction. Basically a 3/4" gap behind the siding to allow air movement. Different types of outside vapor transfer paper, tyvex, are placed over the house sheathing to allow moisture to escape not enter.

Also noticed that the siding goes tight against the windows. Usually a small 1/4" gap is used with a caulk to allow expansion. And the bottom is left open to drain.

How to fix ? I'm thinking that possibly if you sanded it a bit. Got a good paint and stain person to match the color scheme back. And apply 1 coat of topcoat.

Just trying to give you something to work with. And possible causes, fixes. Good luck and stay safe

I notice big gaps between boards too, on that siding, there is moisture getting in there too.

The gaps are part of the tongue and groove. It's in Colorado, high desert - low humidity, etc. And it's happening in sections that are completely shielded from rain and snow. :(

Wow that is some dry conditions. Was trying to think outside the box, and thinking about how you can tie it into your homes decore. If you can't beat it join it.

I hope you are enjoying the rest of your home

If its not being exposed to enough moisture to saturate it, it may have been installed when not yet seasoned to a low moisture level. You can get a moisture reading for how it is now. That info will help with what the next steps can be. Borrow the gauge from your lumber yard.

Yes, or they cost $30 to buying a moisture meter