I have heard it used several times recently, but I had no idea what it meant until I looked the term up on the Internet, because I had never heard it before.
Where does whole cloth come from? How and where is it used?
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Thefreedictionary has an entry:
Pure fabrication or fiction: "He invented, almost out of whole cloth, what it means to be American" (Ned Rorem). "His account of being drugged, kidnapped and tortured was made up of whole cloth" (George Carver).
[From the fabrication of garments out of newly manufactured, full-sized pieces of cloth.]
Another meaning is captured by Answers.com:
This expression is a hold over from the days when material was hand made and very expensive. If a garment was made new from material that had been custom made, it was said to be made of "whole cloth", not a patched garment...
So the expression "created out of whole cloth" generally is admiration for an excellently told tall tale that is usually a new story. Novels sometimes get their start this way.