“Made up out of whole cloth” means to fabricate a story which is wholly false.
Back in the 15th century, “whole cloth” meant cloth that ran the full width of the loom, not yet cut up for sewing. The term dropped into disuse in the 18th century, except in the figurative sense. But by the 19th century, especially in the US, the expression came to have the opposite meaning. Instead of using whole material, as advertised, tailors were actually using patched or pieced or stretched goods.
A lie that is “made up out of whole cloth” is not one that consists of stretching the truth, nor one that is patched together from bits of truth and half-truths. It is a complete lie from beginning to end, a seamless fabric of deception.
A thing made from whole cloth has no previous history or associations, but starts from the absolute beginning, created from a blank, unused sheet in the same way that a total lie is invented.
The word “fabric,” when it first appeared in the late 15th century meant, literally, “building.” It went on to mean pretty much anything that could be built or manufactured, but the definition became restricted in the mid-18th century to being used as we use it, to mean “textile or cloth.”
“Fabricate,” appearing in the late 16th century, meant, of course, “to make, construct or manufacture” anything that required skill. In the 18th century, that “make or construct” sense led to the use of “fabricate” to mean constructing a story. And, by extension, “fabrication” now means a story that is completely false, a lie.
Many of us stretch the truth sometimes, usually to make a good story better. But, to create a completely new story takes talent. Fantasy and science fiction writers create whole new worlds, but they must portray human nature as it really exists, otherwise their worlds would make no sense to us, the readers.